Economic & Market Update: November 24, 2008

“Bank Bailout Part II- Another Turkey?”

Happy Thanksgiving!

Chip Norton, Managing Director of Fixed Income & Economic Analysis

Last Week:

PPI:                                                 Down 2.8%, core up 0.4%       

CPI:                                                Down 1.0%, core down 0.1%

Dow:                                               8046 – Treasury Sec Rally falters, 7000s tested

S&P 500:                                      800 – Test of the lows and bounce

VIX:                                                72.6 – Volatility spikes again

10-Yr Bond:                                  3.23%, Quality Trade Remains

3-mo TBill:                                   0.01%, Getting nothing for something!

AAA 10-yr Municipal:             4.15%, Tax exempt value continues

Dollar/Euro:                                1.27 – Steady as she goes

Dollar/Yen:                                 95.90 – Asian markets firm dollar

Oil:                                                  $51 – New levels below $50/barrel and $2/gallon on gas

Economics This Week:

Date      Item                                                Est.                     Comment

11/24    Existing Home Sales                   5.05Mil                            Softer again

11/25    Q3 GDP (prelim)                        -0.3%                   Weak as expected

11/25    Consumer Confidence                 39.5                     Lower confidence seen

11/26    New Home Sales                         450k                    Down again

Citi Down for the Count – Yikes!

Turns outs that the first $25 billion wasn’t enough for banking giant Citigroup. The deal made last night was for a loan guarantee backstop of just over $300 billion along with a direct capital infusion of another $20 bill to keep the “too big to fail” bank from collapse. In return, we taxpayers get another nice return deal (if the firm stays alive) with a preferred shares swap paying an 8% dividend. Bloomberg reports that the government’s preferred shares come with warrants to buy 254 million Citigroup shares at $10.61 each, allowing taxpayers to profit if the stock rallies following the government’s investment, according to a term sheet that accompanied the agencies’ statement. Citigroup is required to pay a quarterly dividend of no more than 1 cent a share for the next three years, down from 16 cents in the most recent quarter. Terms of the asset guarantees are reported to require Citigroup to cover the first $29 billion of pretax losses from the $306 billion pool, after which the US government is on the hook for 90 percent of the losses, with Citi covering the rest from assets, including residential and commercial mortgages, leveraged loans, and so-called structured investment vehicles.

Of course, it seems that Citi decided that they couldn’t help out the situation by selling, say, its Smith Barney franchise…hey, that would have been just bad business, right?!  All jest aside – the failure of Citi would be catastrophic for the US and world financial system. The amount of counterparty loss alone that’s inherent in such an outcome (not to say anything about the trillions in Credit Default Swap obligations) is almost unfathomable.  The issue for Citi, like that of Bear and Lehman, does not appear so much one of an operational business collapse, but of a loss in confidence by its investment clients. As we’ve seen before, once the rush to the exit begins, it’s the death knoll for the firm. Last week’s stock price collapse certainly looked like the exit ramps were jammed.  This seems to be one bailout that really must work for the banking system to have any shred of confidence left. 

GDP Q3, First Round

This week we’ll see the first round of Q3 GDP. The estimates have it down 0.3% but it’s reasonable to assume it could be worse, down as much as 0.5%. The Q4 estimates are expected to be even worse, with suggestions now showing up at -1% to -2%.  Much of the results will depend on the depth of the retail sales decline, which we already know has made a significant pull back on all fronts. 

Autos in Limbo

Last week’s Congressional action sent the auto makers back to Detroit for a few weeks of number crunching. Seems Washington will give them what they want, but just need a nice written report to show voters there was economic rationale for this cash infusion.  We all hope that there are at least some strings attached to what’s coming in this bailout, such as consolidation, downsizing, and union contract negotiations.

Inflation Dead?

If you missed it, last week’s CPI and PPI data showed one of the largest one month drops on record. For the moment, these two inflation measures are under lock and key. As I have said here before, the real threat is not inflation, but continued disinflation that could lead to deflation. It’s deflation – the inability to raise prices in a squeezed market – that was one of the leading contributors to the Great Depression.

As a side note, this observer thinks that all the free money being printed in Washington these days will come back to haunt future economic conditions in the form of high inflationary pressure in the years to come. Does this mean TIPS are great buys now? Maybe, but the holding periods will have to be years – the rush to TIPS shouldn’t have too much urgency.

Something for Nothing

In Treasury bill land, we are back to essentially giving the US Treasury money and accepting nothing in return – except alleged safety. The 3-month T-bill is now showing an interest rate of 0%. Yup, that’s right folks, we are providing a sweet financing deal for the US government and forsaking all other reasonable investments. This is not much of a confidence-builder for investors. The only good thing is that, at some point, all that money will become very bored earning nothing and will want a better home. Hopefully, it will find its way back to the equity market or at least bank products that have doubled up on their FDIC coverage.

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