The last few days have been … I’m struggling to find an adjective. Remarkable? Amazing? Jaw-dropping?

Let’s just have a 30-second recap of what’s been happening:

• Lehman’s was allowed to go bust. The Fed gave a clear message it would not be the bailout boy in major bank failure.
• American Insurance Group (AIG) came under massive pressure – then got rescued. The Fed gave a clear message that … errr…. it would be ‘the bailout boy’ after all. Sometimes.
• The Lehman’s failure triggered what could be the start of a round of mergers amongst banks. Merrills agreed to sell itself to BoA and HBoS has been linked with Lloyds.
• Stock indices suffered massive falls. The FTSE has lost almost 10% from Monday to Wednesday, the Dow over 6% and Asian and other European indices racked up similar losses.
• The Inter-bank lending market froze up, putting additional pressure on the share price of financial institutions. The share price drops made the banks even less likely to lend to each other and the inter-bank market froze even more.
• Speculation arose that the Fed would cut rates.
• The Fed refused to cut rates.
• Russian stock exchanges suspended trading after share prices slid up to 20% yesterday.

And so on.

In times like this just keeping track of the news can be a full-time job, never mind interpreting and acting on it. Indeed it’s tempting to succumb to Technical Analysis, dismiss the news as ‘already included in the price’ and just look at the charts.

However, for a guy like me who spent the ‘formative years’ of his career in a news agency, staying on top of what is happening is synonymous with being in control. So for this blog I’m going to look at some of the major events and pass judgement on them: Bullish or Bearish. Feel free to lob in your own views in the comments box below – I have no monopoly on opinion.

The Fallout From Lehman’s
Let’s get the biggest one done first. The Lehman’s failure was really pretty well-managed given the circumstances. Its demise was so well-forecasted that many of its clients had abandoned ship weeks ago. However the fallout will still be major:

• Lehman’s had a lot of debt – about $150bn. Some of that debt will have been insured against the possibility of Lehman’s going bust (in the Credit Default Swaps market) and those insurers are going to have to pay out. The rest of it will have lost maybe 50% to 60% of its value, and that loss will be on the books of the debt holder. Either way, the figures are big and it’s going to hurt.
• A lot of companies will have had various assets ‘hedged’ either with a derivatives contract that was taken out with, or at least organised by, Lehman’s. However if Lehman’s no longer exists the value of that contract is dubious. The value of those hedged assets will have to be reduced. More write-downs then.
• Hedge funds work on the same basis as spread betting – they take a large position by putting down a bit of their money and borrow the rest. Those funds who used to be with Lehman’s (and Lehman’s were amongst the top 5 at this game) would have had part – or all – of those borrowings provided by Lehman’s. Now those funds either need to find someone else to provide that leverage (which could be difficult given the current market) or else close off their positions. Despite many hedge funds being able to go short, many will have had long positions open and, irrespective of the direction, unwinding these positions will add extra volatility in the market.

The long and short of it is that the Lehman bankruptcy will reduce the value of a lot of assets. That’ll reduce the value of the companies who own the assets which means the assets those companies have issued (e.g. their debt) will also fall in value. And so the vicious circle gets another boost …
VERDICT: BEARISH. VERY BEARISH. A 10% FALL IN THE MARKET LOOKS JUSTIFIED TO ME

The Fallout From AIG
The award for best quote on AIG has to go to Tyler Cowen at Marginrevolution.com: “It’s a little scary that the world’s largest insurance company hasn’t planned for a rainy day.”

However AIG being saved was a massive move. So massive it effectively took the sting out of the Fed’s decision not to cut interest rates on Tuesday night. I know there are some big issues about moral hazard and that, if the banking sector is to regain confidence, those issues have to be worked through. But if AIG had failed, well … we can all speculate. The truth though is that no-one really knows what would have happened. And the ‘unknown’ could have been the most damaging of all.
VERDICT: BULLISH

Who’s Next In The Firing Line?
The short answer is any investment bank or mortgage lender that is perceived to not have enough cash to ride out the storm. And, with successes like Lehman’s, Fannie and Freddie to embolden them, you can bet the short sellers are looking for their next victim. (Paddy Power are even taking regular bets on it).

Lets talk about the investment banks first, then the mortgage lenders after.

Merrills, Goldmans and Morgan Stanley.
Merrill Lynch must have known they would be next to be set upon after Lehman and they decided to jump before they were pushed. In this case they jumped right into the arms of Bank of America. Their bold move seems to have done the trick – the widely watched ‘Credit Default Spreads’ on Merrill decreased straight after the move. However God help them if the Bank of America shareholders refuse the takeover.

Goldman Sachs and Morgan Stanley both reported a quarterly profit this week (although the FT reported Goldman’s making a loss – whoops!). The profits were predictably well down on this period last year, but they are still a profit and that in itself I find remarkable. What’s more they showed themselves to have plenty of money in the bank (i.e. Tier 1 capital ratios were healthy). However Goldman’s still have some $120bn in derivative contract assets – that’s over 10% of it’s total assets – some or all of which could go belly-up.

I said above that a lot of hedge funds will be looking for a new broker, and the same will be true for Lehman’s corporate clients. However these guys will also be very worried about the same thing happening again to their next bank – many will want to know that their bank has a rich daddy with deep pockets should it run into trouble.

Despite ‘above estimate’ results and decent funding, at the time of writing both shares have been under massive pressure. I suspect the issue is that the market just doesn’t believe either firm will have enough funds tucked away to be able to ride out many more losses or possibly to even attract new clients. The days of the ‘independent broker’ may be numbered.

HBOS, WaMu and Wachovia And The Irish Banks
WaMu, Wachovia and HBOS all face, at core, a simple problem. Like most banks they depend on being able to borrow money at a set percentage and lend that money out at a slightly higher percentage. All of them are paying well over the odds to borrow that money. So, where does that leave their business model?

Like Merrills, Halifax Bank Of Scotland seems to have decided the safest route is to jump into bed with a ‘safer’ competitor – in this case Lloyds. However at the time of writing there was no confirmation of the deal and, crucially, no price mentioned. (UPDATE: Lloyds are paying 279.75p a share for HBOS, a 58 percent premium over HBOS’s last price of 147.1p.)

Washington Mutual (WaMu – what a terrible nickname!) is possibly the bank most under scrutiny from short sellers. Rumours are suggesting they’ll be bought by JP Morgan. WaMu are denying it, although that might simply be a ploy to drive the price up. (UPDATE: The Mole has plenty about this in his Market Watches, and I’m sure he’ll keep us up to date over the next few days.)

What about Wachovia? In an interview with Jim Cramer (is there any escape from that man) on CNBC, Wachovia CEO Robert Steel talked a good game of cutting costs and being ready for “headwinds” in the economy. However when asked about the possibility of Wachovia being bought he didn’t flatly reject the suggestion. And as with dingy nightclub at 3am, anything other than a flat rejection is bound to be interpreted by someone as a “come hither” glance.

Bank Of Ireland announced a dividend cut of 50% yesterday - normally a sign of distress but in these conditions I’m guessing most people will see it as sensible way of preserving capital. The four Irish financials have been hit as hard as their European counterparts, with Irish Life (as the largest residential mortgage holder) and Anglo (with it’s commercial property portfolio) seen as being the most vulnerable. So far all of them seem to have escaped the major write-downs that have afflicted US banks and, unlike HBOS, they benefit from the ECB’s relatively benign emergency funding. However I find it hard to see where the good news needed to lift their share prices is going to come from.

Over the next few days (and no-one can really look much beyond that at the moment) a lot of people might be tempted to short Goldman’s, Morgan Stanley and Wachovia (WaMu is too small to be quoted) including me. A bet on any of them is, for me, a bet against the company having part or all of it bought at a premium to the current price.

Now I’m not sure why anyone would want to buy an institution with a potentially unknown set of issues when they could, like Barclays, wait for the bank to fail and then pick off the tastiest bits. However maybe I’m underestimating the influence of the central banks who, if they play their cards right, get seen to be ‘doing something’ without actually spending a cent.

Also don’t forget the SEC’s short selling ban a few months ago. Either a new version of that or some other sneaky change to the rules could squeeze short positions.
VERDICT: MUCHO CREDIT TO MERILLS AND HBOS (IF IT WORKS OUT) BUT BEARISH ON THE REST

Who Else Could Be Vulnerable?
One thing that strikes me as ironic is that the failures so far have been Banks and Investment Brokers. Hedge funds, which for the last ten years have been seen as the most risky part of the financial system, have largely been keeping themselves out of the news.

A hedge fund house called Harbinger was the latest rumour to do the rounds. Since then Philip Falcone, who runs the fund, has come out to squash the rumour. However sooner or later one of these rumours may be true. When will the first one fail … and how would the markets weather another LTCM?
VERDICT: BEARISH

What About The Housing Market
The Fed taking over Fannie and Freddie have effectively allowed previous interest rate cuts to belatedly be passed on to consumers. Bloomberg report this is already having an impact – with applications for new and refinancing mortgages up 33%. Mind you, applications are still way below where they were at the beginning of the year.

And, with most people either accepting the US is in a recession or accepting it is on the verge of one, lower mortgage interest rates may not have any impact for a good while yet.
VERDICT: BULLISH, BUT ONLY JUST

Inflation & Interest Rates
Well, it seems as though Ben Bernanke has finally found his ‘pair’. The Fed, by not cutting base rates and keeping market-pleasing hyperbole to a minimum, managed to keep what little powder they have left dry.

Cutting base rates would have (in my humble opinion) had little impact in freeing up inter-bank lending – banks won’t lend if they don’t feel they have the money to lend or if they don’t trust the people who want to borrow. Meanwhile the timely intervention with AIG helped to stop markets from completely melting.

The statement that accompanied their interest rate decision talked more about inflation worries than most people expected. Which, to my mind at least, helps them to retain some credibility. However the last couple of days have shown massively conflicting inflation data from the US, Europe and the UK. All three have released monthly CPI data in the last few days.

Both the US and Eurozone CPI show a drop of 0.1% for the month and in both cases a fall in fuel and food were quoted as the reason. UK inflation, by contrast, rose 0.6% in August. Inflation levels are still high, but at least the US one is heading in the right direction. Presumably, if commodity prices continue their downwards slope, UK inflation will start taming too. That will allow scope for interest rate cuts and some ‘fiscal stimulation’ of the economy.
VERDICT: BULLISH – BUT UNLIKELY TO KICK IN FOR A LITTLE WHILE YET, ESPECIALLY IN THE UK.

Recession Watch
There are loads of business sentiment surveys, purchasing manufacturers’ indices and so on that are meant to gauge the likelihood of a recession. And most of the European and UK ones, paint a great picture for sellers.

However it was a small story in the Economist yesterday that caught my eye – bottled water sales are on the way down as European Consumers try to reduce their spending (here’s a link to a similar story). Volvic sales are down 7.4% and Evian sales down 2.5%. I guess that, when things get tight, bottled water is one of the first things to get left out of the shopping trolley.

Is bottled water a good indicator of the state of the economy? I have no idea. But with everything going on in the financials it’s easy to lose sight of everything else. This story was just a tiny indication that a recession is on the way, and it is going to hurt far more than just the financials.
VERDICT: BEARISH ON THE INDICES

So How Am I Trading All This?
I haven’t indulged in shorts on any of the financials so far, mainly because experience has taught me that I’m rubbish at betting on anything outside my core markets of FTSE and S&P. However if I were to take a position on either (or more likely both), and I am sorely tempted, I’ll be keeping my stakes low and limiting my risk.

The other option is of course to look to go long on ‘safe-haven’ assets – after all, people withdrawing money from stocks have to put it somewhere. I haven’t really discussed safe-havens, mainly because this blog is already Godzilla-sized. However some people are talking about the Dollar and the Yen as a safe haven. Excuse me? For my money the only real safe-havens are the tried and tested ones of Gold and the Swiss Franc (have you seen the price of gold over the last few days).

I’ll be the first to admit that I don’t get to trade half as much as I’d like to any more – unlike most of the bloggers I work full-time for paddypowertrader and, in markets like these, there’s plenty to do. However I have managed to get a few short FTSE trades on and in they’ve made me a few quid – 50 points here, 70 points there. In volatile times like these, as I said above, I keep the stake low. That allows me to set the stop loss a good way out without taking on too much risk.

I’ll keep on with this strategy until I can until I see some positive evidence of a rebound – however I’ll be staying away from going long for a while yet. Several times I’ve managed to make money on a major drop, only to lose it all by betting on a recovery too early. One thing I have learnt: a financial market will never turn around because ‘surely it’s fallen enough, it can’t go much lower’!
For an alternative view though you might want to check out the view of a man much smarter and wealthier than me. Douglas Kass seems destined to be associated with Fannie and Freddie in the way George Soros is associated with Sterling’s exit from the European ERM. He reckons this is a good time to be sat on this sidelines. “It is a dangerous time for the longs and for the shorts,” he says. “This is a time to watch and not a time to play.”