Sunday, December 2, 2007

Why I'm Not Covering

Another violent bear market rally. The market should have tanked instead after the awful news this week:

  • Citadel bought a portfolio of E*Trade's residential loans. "Citigroup investment bank analyst Prashant Bhatia said E*Trade actually received 11 cents on the dollar for its portfolio, if you factor in that the brokerage received $800 million in cash minus 85 million shares it issued."
  • E*Trade operated a bank, and these were relatively high quality loans. "...73 percent of the assets were backed by prime mortgages, or loans to people with solid credit." Downey and BankUnited have arguably lower quality loans, but the market is pricing them much higher than what E*Trade sold their loans for.
  • Florida municipalities invest cash in a state-run investment pool. It seems that they were invested in low quality securities, and now Florida Halts Withdrawals From Local Investment Fund. There was a run on the fund, and some lucky cities got out in time. But not Jefferson County - their CFO says "I might not be able to pay our employees tomorrow."
  • The Treasury's scheme to have lenders restructure loans has been on the news constantly. Russ Winter points out:
  • "How exactly does the New Hope Alliance secure the agreement of ten or fifteen MBS holders to lower coupons and terms. ... Credit insurance is also put on against default and against altered conditions. If somehow some MBS were restructured under new terms this would in turn trigger a wave of claims against the credit insurance written against this securities. Would the insurers (if even still around) agree to pay these claims? This scheme as it applies to the mountain of MBS in the marketplace is just too much of a tangled web to ever be seriously implemented."
Ever calm and rational, Gary North wrote a good explanation of the rally:
On Tuesday, November 27, the Dow Jones Industrial Average rose by 215 points. The next day, it rose by 330 points.

Why? ... The news had broken that morning of the offer by the government of Abu Dhabi to pay $7.5 billion for 4.9% of America's largest and most prestigious bank, Citigroup.

The stock fund managers started buying as soon as the news hit. The official interpretation: "This decision by Abu Dhabi indicates that America's largest bank is in good shape. This is the end of the subprime crisis."

Here is my interpretation: A small percentage of a gigantic pool of oil-generated capital, which is managed by government bureaucrats in a city-state whose nation did not exist as recently as 1970, was used to buy 4.9% of the largest bank in the United States because this purchase was perceived as a better deal than buying T-bills denominated in a falling dollar.
Another reason for the rally is the eager anticipation of another cut in the Fed Funds rate. Bespoke did a post showing the reaction of various sectors to the last three Federal Reserve interventions in our markets:

Oops! Similar results in the homebuilding sector, of course. Rate cuts aren't going to keep the lights on if you're a real business that made bad investment decisions.

I put together a chart showing the performance of the Credit Bubble Stocks from this blog. Each data series begins on the date the stock was first mentioned on the blog.

(Click for larger version.)
S&P and cash are included for comparison.
You can see that Fed interventions and mistaken bullishness have caused sharp rallies, but they are fleeting and reality quickly catches up with the market.


Anonymous said...

Great Site.
Could you comment on HRB.
I think it is a good shorting target, with its dec 11 earnings call.

CP said...

I'm not too familiar with it, except to say that everything I've heard is bad.

I will say that the market reaction to the earnings call depends on
1) Whether we are still in a delusional bear market rally mode.
2) Whether management is honest about taking losses. (And I think that the market will reward dishonesty, as it has for other companies.)

Deborah said...

I think the rally will be short. It is utterly insane. It makes a lot of sense that Citibank has gotten money at 11% and will in turn loan it out at what, 6%?

When you factor in the rate being given, Abu Dhabi is only paying about 60-65% of what other investors are paying. I personally wouldn't consider buying Citibank at $10, but if you think this Abu Dhabi guy knows what he is doing, investors could at least wait until Citibank is at about $20-22 to buy...