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Many people are wondering what is going on in the markets. Why are all the brokerage firms and banks collapsing? Is my money safe at XYZ?

Since the Federal Reserve, White House and Senate Banking Committee are all noticeably absent in explaining what is occurring, I will give you a brief synopsis. Fear is a lack of understanding of something, and once you understand what is occurring you may feel better about things. I believe this is the one exception to the rule and once you understand what is going on you will likely be even more concerned. I will let you be the judge and report only the facts.

In mid-June, 2007 Bear Stearns announced that two of its hedge funds were on margin calls and Moody''s downgraded their debt. After the downgrade it became almost impossible for Bear to sell the debt and the firm eventually elected to eat $3.2 billion to take over the fund''s risk and positions. This was the first noticeable fissure. No one thought too much about it as those “hedge funds” have a reputation of being a double-edged sword.

The Bear debacle was the first time many Americans heard the term “subprime mortgages” but were reassured that the market for such mortgages are small. Like all Americans, we have a short-term memory deficit from eating too much Coo Coo Crispies in the morning, washed down by a Coke and 2 Starbucks before we get to the office.  Many of us naively and somewhat accurately rationalized the problem as something created by Congress to give the poor and disadvantaged access to the American dream whether or not they could afford it, so let Congress figure it out.

Not long after the first mention of subprime came, more moles popped their head out. A bank in London had to eat $900+ million in subprime debt. Eventually the Central Bank was forced to flood the economy with fresh capital. Problem solved, right?

Not so quick. It soon surfaced, as these things always do, that Citigroup had a problem on their hands too. It was come-clean time, so Citi did so. Like a child who minimizes his culpability in the broken window incident by simply admitting that he was there when it happened, even though he was the one with the baseball bat in hand and at the batter''s box, Citi stated the problem was only a few billion.

If Citi is having problems, then everyone may be having problems. The Federal Reserve listened to Jim Cramer enough times calling them “shameful” for not lowing rates, and decided to act. They lowered rates 50 Bps on September 18, 2007 and another 25 Bps in October. After all, we can''t have fear in the months notorious for market crashes, especially on the 20-year anniversary of another crash. This did resolve the problem, or so we thought, as the markets began their ascent to record levels with the Dow at 14,000 in October.  Ben Bernanke, the freshman Fed Chairman, was finally starting to look good to Wall Street.

Eventually a “come clean” time came for everyone and major firms started rattling off their laundry list of SIV, CDO and subprime losses. Third quarter numbers reported revealed their original estimate of a $5 billion loss was closer to $8.4 billion – Oops!  Stan O''Neal was fired. Citi decided their abacuses were a little warped and that their $6 billion loss was really about $11 billion. Citi''s CFO stated in a conference call that they really don''t even know the extent and it could be above $11 billion.

We are now looking at as much as $500 billion in subprime risk – but like an iceberg our economy, The USA TITANTIC, is facing just the tip. Underneath the surface lies corporate debt, commercial paper, credit card debt and other portfolio debt. It is so bad that soon we may be hearing about municipal bond failures. Yes, entire towns may be going out of business and unable to carry its debt load.

What did we expect? If a homeowner spends more than they make, eventually they have to bankrupt, right? If you spend $10,000 a month but only net $9,500, eventually the money has to come from somewhere. In the past a rising stock market and appreciating home values were enough to get Americans out of their spending jam and into a new plasma TV after the refinance. But what happens when the Dow falls almost 3,500 points in 11 months and home values fall 30%. No more borrowing for Joe Q. Public.

Unfortunately, corporate America and governments have not had to live by the same constraints. When a city or nation runs low on money, they just borrow more. Towns base their home owner''s tax rate based on a percentage of the home''s value, but what happens when home values decrease? Cities take in less money, not more, even though they have an ever expanding budget. After all, that road they fixed last year needs to be dug up again and repaired this year or unemployment will spike.

Towns, cities and the nation have gotten clever. They issue bonds and raise taxes. Right now we are taxed so ridiculously high that our forefathers would roll in their grave for wasting their time throwing tea into the Boston harbor. So during election years instead of raising taxes directly we do it indirectly. We legalize gambling in towns or have a lottery.  We hide a few cents more in gas taxes, leaving the consumer asking why they pay $2 for gas in Mexico and we have to pay $4.29. The city I live in has gone from a 7% sales tax to 10.25%, a 46% increase.  I know I do not see a 46% increase in the quality of roads. I know the 110 man police department has not gone to 161 men.

If homes keep up with or surpass inflation in appreciation and a city doesn''t increase its services, then the taxes raised one year should be adequate a few years later. Think about it. If the city has a standard cost of inflation increase in expenses of 4% and homes increase 10%, the additional tax on home values should be adequate not to have to raise taxes. Not so.

I know the town I live in decided to raise taxes $2 per pack on cigarettes in an attempt to raise additional tax dollars. The geniuses that run the town were counting the additional revenue by taking current annual cigarette sales and multiplying this number by $2. Meanwhile, the $80 cigarette cartons were selling for $55 on a 5-minute drive away, and they were selling for $39 if you wanted to drive 20 minutes north. Guess what happened? The city that thought was it was getting rich actually ended up losing revenue and are stumped at how to fix the problem.

I state the cigarette example not as a way to vent on my town, rather as an example of what happens when government and business run into each other. The government put pressure on mortgage companies to lend to the poor and look at what is unraveling. When government tries to legislate homeownership, a bubble forms.

Most people think of a bubble like the Nasdaq bubble. Prices reach astronomical levels and then the bubble pops. Eventually things get to levels that are realistic and a new bubble forms somewhere else when greed eclipses fear. We are facing a menace 100 times more devastating than oil at $150 p/b. We are facing a bubble of lending and credit confidence that is exploding into fear. When you can''t borrow money at any rate because those who have it are afraid to have another bad loan on the books, you are looking at the gates of Hades.

I am not going to take sides on the Republican or Democratic political party stance and what contributed to the mess. It is a common and credible belief that liberal government (either liberal Democrats or Republicans) policies of the 1970s and 1980s contributed as much as unregulated SIVs, CDOs, and other debt swapping instruments that people believe are safe because the risk can be calculated by some theoretical model. Models are fun when one is a child, but as an adult things need to be treated more realistically and maturely. Besides, didn''t Long-Term Capital teach us models are only as good as the person reading the printout?

So what happens now?

That is a $1-$5 trillion dollar question. Most experts believe we are looking at a $1-$2 trillion problem. I agree with their estimates as I am too uninformed and lazy to do the math on my own. I do know that if history is the judge of anything the government estimates, like George Bush''s $1 Billion Max price tag on the war, the estimates are best-case scenarios. That is how we are given bad news. The news comes out and shocks us. By the third or seventh increase in price we as a people are so upset, tired, frustrated, and angry that we don''t even care anymore.

My guess? This depends on big business and the Federal agencies. If the past few weeks of silence is any indication of what we can expect from our elected officials, things will be catastrophic. People are on Suze Orman, Jim Cramer, and anyone else who knows anything asking, “Is my money safe?” People are scared and no one is calming us down. If we have to live with a big brother shouldn''t they be there minimizing our fear of the boogie man when we get scared?

So far all that has happened is the Fed decided it would help AIG out because they don''t want the 130+ countries AIG does business in upset with us. They decided Lehman would die, but then again I would too after hearing of the CEO''s arrogance. They are basically saying they are going to decide ad hoc who they feel is going to survive and who is going to fail. I guess it helps if some of those losses came in the form of campaign contributions.

What would I do?

This really doesn''t matter as no one would put me in charge. I admit I can be bought and that violates the rules of conduct and secrecy in DC. They are prostitutes, but discreet prostitutes.

What should be done is the Resolution Trust Corporation should be put in charge of the clean up and given a blank check. The RTC was originally formed to liquidate assets in failed S&Ls to help protect investors, the FDIC, etc. They have some experience in liquidating assets and thus the Federal Reserve should not have bailed out AIG.

They should take ALL insolvent companies that want or need to participate and dump it into one large MIF (multiple investor fund) to slowly and orderly dissolve the assets of defunct companies. Any company or wealthy individual looking to bottom fish for good investment opportunities could sift through the portfolio and purchase what they want. The RTC will hold onto the asset as long as they exist or until maturity to avoid a fire sale and massive liquidation. Who wouldn''t want to purchase a $1 billion stock portfolio based on today''s closing prices if they knew the credit crisis that was forcing our markets lower were being taken care of? We know the portfolio was perhaps worth 30% more 11 months ago.

I would institute an immediate and strictly enforced up-tick rule in all instruments dealing with finance or financial institutions, or any company wishing to have their name added to the list. Anyone caught violating the rule would be subject to heavy fines, loss of licenses, imprisonment and worse.

I would open the Fed window and start pumping money out in bushels. Inflation worries? I am looking at a Yahoo headline saying “Worst crisis since 1930.” I am not worried about inflation. I think people would gladly pay $6 for gas as opposed to standing in bread lines. I would also like to put the CEOs of these corporations in front of Senate oversight hearings for a few months and let them sweat like we are. Take away their $30 million golden parachutes and give it to the RTC.

This deleveraging, or "unwinding of debt,” can get very scary and if we do not treat this crisis with the same sobriety we would while making a decision to allow our child to go to the Gulf, then we deserve what ensues. We CANNOT do too much. I have been one who historically looks at every major selling as an opportunity to sell puts on high volatility, but this one has even me spooked. Perhaps I would be more confident if anyone in D.C. seemed to know what they were doing or willing to do something. I guess with a Presidential election 7 weeks away, no one wants to stick their neck out.

Until something dramatic, drastic and exhaustive is done I suppose that every stock market bounce is a selling opportunity. I am fearful that the romantic stories my grandmother use to spin about having to do without and being happy for a piece of meat on Christmas is coming our way. We have big business to blame, but the real culprits are the elected officials who forced big business into creating hybrid derivatives to lay off risk in the subprime market. Even the poor deserve the opportunity to buy a $100,000 home; refinance it for $200,000; spend the $100,000 taken out on junk to keep the economy going another quarter; and then walk away from the home when they can no longer afford to carry the debt. I am sorry if I am overlooking putting blame on the bank appraisers who would show up at your house during the refinance process and ask you, “How much do you need the loan for?”

As for the markets...

We saw the worst. I think the hardest part of this is over. Why?

1. The VIX is above 41% at the time of this writing. This is a huge fear level that hardly ever sustains itself and is usually a leading indicator of a bottom.
2. The UK just implemented a short sale rule forbidding all new short selling until January. We will follow their lead.
3. Senator McCain decided to contradict the President and call for the resignation of Chris Cox, the head of the SEC. This is a ballsy move and an important first step in one of the candidates looking like he has some opinions or a plan to fix the current quagmire.  Senator Obama will be playing catch-up from here on out, and will be throwing suggestions into the hat. This will not only likely appear clear what his real objective is but push McCain ahead in the polls. When the markets know who is likely to win they can start scooping up stocks in anticipation of the market''s belief of what companies will benefit from his Presidency.
4. Companies are reiterating their financial strength and that the short selling is a game. We will see (perhaps) some people in a year doing the “Perp Walk,” but in the mean time any good news is another emotional uptick.
5. The market fell from up 150 on the day to 10,500 after Bush''s pathetic speech. His canceling his trip to watch the markets is of no more benefit than me sitting in a waiting room supporting the surgeon working on my parent''s bypass. My dad is happy to know I am there, but I really am not doing much to assist the problem.
6. Once the markets hit stops at 10,500 it predictably fell fast, but once they cleared out the stops the market bounced back fast and furious. Right now it is at 10,600 and I am predicting it goes much higher today.
7. The S&P is trading on a PE of 12. This is substantially lower than the 26 PE it was last year, and an indication great stocks are being beaten down too hard.
8. The worst of the news is out there and there is much fear of the unknown. That is about the worst ingredient for the market (fear of the unknown). Anything from here, even bad news, is better than no news.
9. Once the Fed reassures everyone their money in the bank is safe we will be back above 11,000 and wondering what all the fuss was about.

This is not to say we are out of the woods and the markets are going to calm down. We still have a long road ahead of us. We will likely see the Fed eat over $1 trillion to fix the problem, but that is still cheap compared to what we spent in Iraq.

How to trade this?

I am forbidden to give advice be it tax, investment, etc. I can say that I doubt the VIX will get much higher so I don''t think I personally would want to be long premium with the VIX on a 41%.

Some of the financial stocks have been hammered. Getting long the stocks is a bottom fishing technique for the brave, but I saw some on CNBC were long the XLF and had it collared for protection. Being long a put and short a call is usually designed to be volatility neutral so high volatility is not a problem. 

Anyone wanting to learn more about how powerful a collar is and how to trade it is encouraged to become educated about them before attempting them on their own. Optionetics extensively goes into the collar in both the ICT and PoMM class, so feel free to contact our office to enroll in one of them. The cost of tuition is obviously cheap compared to what many have already gone through not being long protection.

Many ask what they can do to get long other than buying stocks or naked options. Long verticals by definition minimize the high volatility issue. Directional time spreads are also often favorable to naked options in both risk reduction and volatility protection. Those more knowledgeable also may elect to sell verticals to achieve their goals.

Those wishing to safely short high volatility can go into strategies such as condors, iron condors, short time spreads and the like.

Scott Kramer
Homeless
Optionetics.com ~ Your Options Education Site

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