Its In The Price, Baby!

Things we know, some pretend experts will always say "its in the price". Is it really in the price already? Stock markets are forward discounting models, hence it would be silly to think that any known news would not be in the price already.

So when the banks started falling like bricks, markets fell. But when Lehman Brothers was allowed to fail (Paulson's gravest mistake), that was akin to saying all bets are off, that no one was big enough not to fail. That is why, in many ways, the collapse of Lehman Brothers paved the way for extreme risk aversion. Investors were calmed when AIG was rescued, followed by Fannie and Freddie. However when Lehman Brothers were allowed to fail, investors realised that other troubled entities might not be rescued.

Having realised his mistake, Paulson and Bernanke basically set about rescuing everything they could. Well, not everything, but every big thing. So, when something's in the price, it depends on the logical chain of events that follow - if that's the case, then its in the price. When something out of the ordinary pops out, then its not really in the price yet.

Markets globally collapsed by between 40%-60% over the last 13 months. One can say its in the price, right?! Well, yes and no. The fall is discounting the recession that will be pervasive. While earnings is expected to be bad, no one is certain how bad and for how long. While there have been extreme fiscal measures by most governments, investors will want to see the execution and implementation are done speedily and effectively (not drawn out over 2-4 years).

The markets was priming itself for a bear market rally stepping into the new year, but was halted by rumours of worse than expected losses by some major entities, e.g. Deutsche Bank, HSBC, Bank of America (having problems digesting Merrill Lynch) and Citigroup. The biggest factor has to be Citigroup as it was not just bad earnings but rather whether the entity will even exists. The losses for the latest quarter was not as bad as the rumoured $10bn. Still, steps have been taken to shrink itself down, so markets are calmed somewhat.

Of more importance was Bank of America. The company just received another $20bn to ease their absorption of Merrill Lynch. So far, they have received $138bn in government aid. What is more noteworthy is that their market cap is only approximately $50bn. Technically speaking, you might as well fold it and restart 5 new banks with the $138bn. However, its not as simple as it looks. Allowing Bank of America to fail is not just wiping out $50bn in market cap, it will also trigger a domino effect of counter party transactions failing. The ramifications which could erase more than ten or twenty times the $50bn Bank of America is worth. The confidence issue will take much longer to return should that happen.

Jim Rogers and those market purists will argue that the weak should be allowed to fail, and that no one should be too big to fail. But the reality does not allow for textbook style economics to be implemented. There is the bigger picture to consider - governments have to contend with the aftermath and flow on effects. You may be able to handle a10% unemployment rate, but what if it escalates to 20%, the social costs will be too great. You may even have to go to war to keep employment up.

Markets have fallen 40%-60%, so some of the recession and poor earnings have been factored in the price. Whether the markets have priced in all is debatable. I am of the minority group viewing that the markets have more than priced in the decimation in demand, poor earnings, company failings (look at the yields on non-prime corporate bonds) and jobs losses. To be sure, I think job losses will continue to worsen and may only peak in March/April, and till then I expect even a few more big companies failing ala Nortel and possibly Motorola. Though not publicised, already more than a few hundred small regional banks and mortgage firms have already closed sop in the US. My biggest argument why the markets have over-discounted the weakness is the absolute non-existence of confidence, and the extreme risk aversion to assets of almost all types. The de-leveraging basically just sped up the entire process. have you see how fast and hard commodity prices and shipping rates have collapsed. This is not a slow death, it is a swift reaction, anything seemingly left standing got its head chopped off, within or without reason.

The committment by the Treasury in the way it is treating Bank of America and the likes shows that they will not let another big entity fail. While many will be pooh-poohing Obama's $1 trillion stimulus, saying that its in the price... come to think of it, its not really in the price considering the markets were at the same level it was 2 months back when Obama wasn't even elected??!! Why do they say its in the price? Its the bear's normal reaction - give me anything, give me any news... I will say the good news will be in the price already, and the bad news that appears are not properly discounted yet. Give the bears any news, it will be considered as in the price already for sure.

I am not saying the bears are totally wrong, but one must view the developments with a proper view of developments. All it takes is just a minor improvement in risk aversion and confidence, and you will find things moving quite fast already. Looking at the markets for the last 2 days, even when the Dow flirted with the dubious 8,000 level... there was sellers' exhaustion. I am not trying to talk you all into believing all is right with the world, but that its not as bad as things seem.

p/s photos: Haruna Yabuki

Update On Fate Of Citigroup

This is probably not a politically correct joke, well not really a joke as it actually did happened, but hey....loosen up. A private banker called up a client telling him that Citi was a great buy below $5. The client half-jokingly said, "What, you kidding, I'd never buy an Indian bank". I guess its not just Vikram Pandit but a huge layer of the bankers at Citi happen to be Indians - I told you it was not politically correct!

Anyway, some updates on the probable fate of Citigroup. The shorts are doing it to Citi, make no bones about it. Will Citi go bust? Very unlikely. The bank has $2 trillion worth of assets, the question mark is how much will have to be written down. Hence even below $20bn in market cap, Citi may not find buyers for the whole bank unless they come with Treasury backing and guarantees.

Citi has kind of been off the radar when Lehman and Bear Stearns were collapsing because of their strong deposit base, in particular from outside of the US. It has some $880bn in deposits, but the scare over the last few days probably would have seen at least one third of those deposits being pulled out. I doubt very much Citi can function without some kind of help over the next few days.

The interesting bit was that the company bought back $17.4bn in assets it could not offload under the SIV. If you were really in trouble, would you do that as a priority? Citi saw Alaweed upping his stake from 4% to 5%, that didn't help. Citi got a $25bn injection from TARP, that seems to be insufficient. The estimated further writedowns over the next 3 quarters could come up to another $50bn. Take that with a much reduced deposit base, and Citi would find it very hard to raise funds or have sufficient capital to do business. While HSBC or even Royal Bank of Canada would have the muscle to buy Citigroup now, none will try as they will not get any special treatment from the US.

For JP Morgan or Morgan Stanley to buy, they would probably only do it with guarantees from the Treasury. Following the hoopla over the deal with JP Morgan and Bear Stearns, I doubt the Treasury would want to take that path again.

A seizure by FDIC would be bad news generally as Citi would be broken up and sold in parts. A most likely scenario now would be for Treasury to become the majority shareholder of Citigroup by pumping in at least another $50bn in exchange for new shares. Taking a leaf out of UK's experience with Royal Bank of Scotland, that seems to work. Treasury could then slowly sell down its stake when Citi gets out of trouble a few years down the road.

As it is, Citi is a unique animal. Its reach is far and wide. If it was Bear Stearns or WaMu, nobody outside the US would bat an eyelid. But mention Citigroup, it trades and do business with almost every corner of the globe. The international pressure on Paulson and Bernanke to "save" Citi would be overwhelming. If that route is chosen (as I think is most likely), we should see it trading back at $10 minimum, thanks also to the short squeeze on the shorts. For the time being, that seems to be a realistic solution.

p/s photo: Nozomi Sasaki