Earlier this week, I recapped the market phenomenon referred to as a "Flight to Safety". In such a situation, investors flee riskier investments, in favor of assets that are more secure, such as oil, treasury bills, and gold.
What happened today is clearly such a Flight to Safety.
As you know, the Federal Reserve announced yesterday it would lend $85 Billion to help stabilize troubled insurer American International Group, a company that insures homes, cars, businesses, and mortgages, among other things, while investing its assets in stocks, bonds, mortgages, and other investments. This loan came with a very high price: 11.5% interest on the lent funds, and the possibility of a nearly 80% equity stake in the company. At today's closing price of $2.05 per share, that 80% stake is worth a paltry $3.87 Billion.
A good investment? At the 22:1 payoff that is needed for the equity part of that equation to work, there's another term for that:
BET.
On a roulette table, there is only one bet that pays out greater than 22:1, and that is playing just a single number. Of course, the government isn't just betting on the likelihood of its equity stake paying off, rather, it made the loan because it feels there is a reasonable chance that AIG will be able to repay the loan, with interest, and, at current rates, assuming the Fed is vindicated, there will be a tidy payoff. If the Fed can borrow the $85 Billion at current market rates around 3.4% for government borrowing, it will make about $13.7 Billion in net interest income over the 2 year term of the loan. If the Fed is wrong, guess who will be holding the bag on that $85 Billion.
If you guessed us, you are correct.
Wall Street thought about this possibility today, and decided it didn't like that outcome at all. Sharp selling ensued, leading to a greater than 4% decline in all major indices.
Remember, when investors sell one class of assets, for today, stocks, they typically buy another. Today saw investors aggressively buying crude oil, pushing its price up about 7% to just over $97 per barrel. Gold saw its largest one-day increase EVER, increasing by $70 on the day, nearly a 10% increase.
The big story of the day was on the money market where short-term investments maturing in less than one year saw huge trading volume, and a price surge that caused their yields to drop near zero. At Tuesday's close, the 3-month treasury bill was priced to yield 0.64%. By day's end today, its yield stood at 0.01%, a decline 63 basis points. The 6-month treasury fared even worse, dropping 74 basis points in yield to close at 0.69%. Essentially, this means that investors are willing to sacrifice all possibility of return on their investments just to have a chance at those investments holding value.
Of course, when stocks are down 4% today, and nearly 8% since Friday, just holding value doesn't seem so bad, does it?
Mortgage rates may see some benefit from recent events in the future, but at present, all mortgages are viewed as risky investments, and as a result, the lower demand for risky investments has pushed up mortgages slightly this week. At 2006 risk levels, 30-year fixed rates should be approaching 5% right now. Instead, they are hovering just under 6%. Hopefully this government intervention will help to build a foundation under the market.
Please check back Friday for an update on the Mortgage-Treasury Spread!
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