It's a Great Time to Be Afraid

It's a great time to be afraid

In some situations, fear is the appropriate response -- and this is one of them. Why? The bailout plan is riddled with loopholes, and new crises are brewing for US cities, states and oil refiners.

By Jon Markman [MSN – MONEY]

Fear is getting a bad rap in the market these days, which is a shame because it's a basic instinct that deserves respect. We often hear that greed is the way to go when markets trade down, but that's not quite right. Fear works, too. Fear clarifies. Fear is good.

I saw fear work its magic most recently last Friday while visiting a ranch in south Texas. Down in the scrublands to hunt doves for the weekend with some friends in the oil and gas trading business, I could see fear rise in my companions' faces while taking a midday break from the heat.

They were watching Congress vote on the $700 billion bailout bill on a big-screen TV while sipping beers and putting away shotguns, and they all seemed to know instinctively that it would lead to disaster. The fear prodded many to act, taking turns on a laptop to type in big orders to sell futures as the major market indexes crested in the afternoon before rolling over into what would become a historic dive this week.

Fear works best when it comes from knowledge and not terror. It is good when it bolts from your guts to rouse your brain from complacency, forcing you to act more on instinct than just reason. It cuts through Wall Street's myths to let you know that danger lurks and you'd better do something. In such situations, he who panics first panics best: A year ago, when Satyajit Das first warned us of global deleveraging, was a good time to fear. So was last Friday. Live and learn.

Loopholes in a 'joke' bailout

Emilio knows all about the intersection of fear, lies and action. He worked as an energy trader for Enron back in the day, and lived to tell the tale. He now trades gasoline futures for a major refiner, and he chuckled at the spectacle of legislators appearing to believe they were stanching the credit crisis with their vote. "If you really read the bill, and understand how it will be interpreted, it's the scariest thing you ever saw," said the trader, who asked me not to use his real name. "These guys have no idea what they're unleashing."

Emilio knows, because he learned from the master manipulators at Enron. For an example, he said, check out Section 113 of the bailout bill, titled "Minimization of long-term costs and maximization of benefits for taxpayers." This is the section that Congress haggled into the bill to ensure a payoff, via warrants, for citizens if mortgages purchased from banks are later sold for a profit. Yet Emilio says bank lobbyists snookered the government by sneaking in an exception under subsection 3a, "Conditions on purchase authority for warrants and debt instruments." The clause, titled "Exceptions -- De Minimis," states that any debt instruments worth less than $100 million won't trigger the payback provision.

Emilio says that banks will simply issue their debt in tranches of $99 million or less, and avoid allowing the government -- and thus taxpayers -- to get a piece of the banks' profits. "It's a joke," he scoffed.

Other traders who scanned the bill came to the same conclusion, through their own prisms, agreeing that the bill would provide only an illusion of action while failing to address the key problems facing the financial system: Too many houses will remain on the market; they were bought with too much leverage that is vaporizing in spurts; and those losses have left banks with too little capital from which they can lend. Even worse, the traders pointed out, the government can make money on the loans only if it pays so little for them that they can be sold at a much higher price. And yet if the government doesn't pay enough, then the banks won't receive enough to make a difference in their balance sheets. So here's how the taxpayers will be cheated, they said: Banks will take advantage of the suspension of mark-to-market accounting by stating that loans originally held at "par," or the equivalent of the purchase price, and now valued by the market at 20 cents on the dollar, will really be worth 85 cents if held until the loan matures. The banks will then sell the loans to the government at a fake discount of 75 cents on the dollar.

"The lobbyists made sure this bill was rammed through so that these rip-offs couldn't be fixed in committee," said another trader. "Everyone on the Street knows it solves nothing."

In fear we trust

This is why there's a bear market in trust, even among the elite. So perhaps that is why fear last week was the appropriate response. Consider that most of the traders I talked to believe that as poorly as U.S. banks have acted in acknowledging and dealing with their losses, the voting Friday threw into sharp relief the fact that there is no similar effort in Europe.

Banks on the continent have acted under an even looser regulatory environment than in the United States, and have piled up even more leverage than U.S. banks -- all of which must be unwound. This week, European banks tumbled even faster than ours, with the Royal Bank of Scotland (RBS, news, msgs) plunging 43% on Tuesday alone.

One trader I met in Texas, who specializes in energy finance, said he was pushed into a fearful posture by the complexity of the task ahead for the Treasury as it tries to implement the bill. He observed that Secretary Hank Paulson was expected to name a 35-year-old aide to run the program, and the companies rumored to be involved so far are experts in mortgage-backed securities and derivatives but not in valuing and selling mortgage loans.

It will be so difficult for the Treasury to set up all the monitoring and valuation systems, and get outsourced vendors in place with new contracts, that it will take much longer than the market expects to get the first dollar flowing to banks, and by then it may be too late. The longer it takes, the higher the costs will be. Making matters worse is that all this is happening during a change of presidential administrations. In this context, no wonder the trader was fearful it won't work and was selling on Friday.

The next few shoes to fall? The traders pointed to a looming disaster in municipal finance, where cities and states that have lost their backstop from troubled insurers are facing lower property- and sales-tax revenues from withering home values and shrinking consumer sales. They said they would warn investors to steer clear of muni bonds -- even though their yields are becoming incredibly rich -- until it is clearer that governments will cut spending enough to ensure payments won't slow.

Worries in the oil patch

And finally, because he specializes in refined petroleum products and sees the sales figures daily, Emilio said he suspects the accelerating global slowdown will slash demand for gasoline and heating oil to the extent that major U.S. refiners like Tesoro (TSO, news, msgs) and Valero Energy (VLO, news, msgs) may face the greatest financial challenges of their lives, potentially to the extent that the government will be forced to nationalize them.

He points to the sharp drop in miles driven in the United States; the $25 billion federal loan to automakers to develop more-fuel-efficient cars; and the massive, sophisticated new refinery being built in India that's expected to produce as much as 20% of world supply when it comes fully on line -- dwarfing the increasingly old-fashioned U.S. refineries. "There's just a lot more molecules coming into the gasoline pool from overseas," he said, "and that has to put our refiners in a bind."

In short, fear can be quite rational if exercised at the appropriate time. Right now is probably a good time to worry that any recovery from the credit disaster will not be swift, and may next have second-order affects that rip down muni bonds, refiners and more as the economy slows.

The markets may bounce now that the world central banks have coordinated on huge interest rate cuts. But after the effects of that wear off, don't be so quick to dismiss your fears.

Yet it's trickier than that. Longtime readers know that I have highlighted the 960 level of the S&P 500 ($INX) all year as my target for a 2008 low, and that level was hit in overnight futures trading on Tuesday.

There's an opportunity now for a 300-point move higher in the S&P 500 as world central banks finally coordinate on huge interest rate cuts and smart traders with cash switch to the fear of missing such a major bear-market rally.

After the effects of that wear off, though, perhaps around the 1,300 level, don't be so quick to dismiss a renewal of concern gnawing at your conscience.