The Economy Guy

Stocks – have you read the newspaper this morning asking if we had hit the bottom, and stocks would only go up in perpetuity?  The answer is NO.  Stocks closed down, in their current bear cycle, 251 points.  The bears are eating the bulls alive.

No change in the bond market.  The Dollar strengthened a little today.

Oil (and gasoline) ended down today as the ugly stock market performance dragged this commodity down.

Gold lost $7 today, but was down $25 earlier in the morning.  When stocks cracked, and panic set in, people fled back to gold.  A very positive sign for the metal.

In the news today….

President Obama’s auto industry task force all have something interesting in common.  They almost entirely don’t drive American cars.  My opinion is that this is a good thing.  These folks won’t be blinded by Detroit prejudice.  Hopefully, they are not receiving any auto money for their pet projects – i.e. undue influence on their judgment.  At a minimum they should all believe (because they voted with their wallets) that Detroit has not produced cars that a major section of Americans want – and the Asians did create that car.  This has been a blind spot in Detroit thinking in the past.

Oil started on the upside today because there was a belief that the government would bail out Citibank.  The idea goes that this would calm the markets and be good for America.  Here’s my problem with this (il)logic. If the government bails out Citibank, does this mean you will buy more gasoline?  Probably not.  So, where’s the major upward driver on oil prices?  Lesson: Just another example that you must always question the headlines you hear/read on the news.

What’s all this fuss about Citibank????

Citibank is the lightning rod of the issue on how to value the “toxic mortgage securities” that Citigroup and lots of other major institutions hold.  Citigroup is the bank closest to bankruptcy – so the press is concentrating on them.  

Here is the problem:  How do you value this junk?

If you remember in a previous economyguy, I wrote about how these securities are valued.  Today, banks have valued them by discounting the face value of the securities by an arbitrary amount – let’s say 10 to 15%.  How could this be justified?  Well, if you have a bundle of mortgages, and, on average, 10 to 15% of them are in default, you can make this case.

However there is a major flaw in this thinking.  The current default rate is only the tip of the iceberg.  Projections of future defaults are significantly greater than the current amount.  So, if you were buying these securities, what would you value them at?  Their current value, or their potential future value?  Market always value in “future value” terms.  That’s because this is the value someone would be willing to pay today for the security.

And now we are at the dilemma that the government finds itself in.  You can bet that the Mortgage Rescue Plan announced last week by the President was meant to slow the default rate, and therefore increase the “future value” of these toxic securities.  Did you see anyone in the press talk about it in those terms????  I doubt it.  However, this is secondary to valuing these securities today.

The government today is doing a “stress test” on all banks – especially the big ones.  If a bank fails the stress test, the government will give the bank some additional money to keep it afloat, rather than force it into bankruptcy ala the FDIC.  This is a temporary measure to keep everyone going as the government decides how to really solve its insolvency problems.

If the toxic securities were valued today at their marketable value – in other words “Mark to Market” value – the decrease in the Balance Sheet of lots of institutions, but especially Citigroup, would mean that they are bankrupt.  And, the FED/Treasury/FDIC would have to step in and close the bank, find a buyer for the worthwhile assets, and sell off the rest at a fire sale.  That’s the way the Saving and Loan debacle was handled.  However, to date, Citigroup has been labeled “too big to let fail.”  In other words, if Citigroup were allowed to fail, the unintended consequences would overshadow the disruption of bankruptcy.  However, is this true, or is it just that no one knows what those unintended consequences really are?  Who knows??  No one is talking about it in these terms.

What are the alternatives available to the government?  TARP Funds – already used as $20B plus $25B has been given to Citigroup to purchase preferred shares.  Nationalization of Citigroup – a politically negative term for the government taking over ownership and control of the bank.  Buy the “toxic assets.”  Change the deferred shares into common shares – today’s favorite in the press.  Let’s look at each of these.

TARP Funds

$45B in TARP funds has already been injected into Citigroup.  The US Treasury received in return a whole bunch of preferred shares of Citigroup.  This was all done under the regime of Treasury Secretary Paulson – and considered an improvement over outright purchasing of the toxic securities as initially discussed with Congress when the TARP bill was passed.

The results speak for themselves.  The injection of the TARP money stabilized Citigroup – in other words it allowed Citigroup to meet the banking requirements for reserves – at least for awhile.  However, it has become clear that these toxic securities are decreasing in value over time, and the stock market has valued Citigroup accordingly – down, down, down…

In other words, the TARP solution has failed.  It clearly is not the long term solution desired by everyone.

Nationalization of Citigroup

This would involve taking over Citigroup in one form or another.  Most people imagine this will be the government walking in the door and running the teller windows from that moment forward.  The idea is to keep the bank open, but controlled and run by the government.  (I will ignore all the political overtones and rhetoric around this idea, and just concentrate on the economic factors.)

This idea could be horrible or could be great.  The devil is in the details.  If the government runs the bank forever, it could be horrible as everyone agrees that the government doesn’t know how to run anything well.  If the government plans to run the bank and make it healthy, and then sell it back to the private sector, this could turn out well.

The Nationalization idea could take the form of integrating part of a bankruptcy action as part of nationalizing.  In other words, it could include selling off some good and bad assets.

We might see this option taken in the near future.

Buy the “toxic assets.”

This was the original idea.  The problem is that if the government buys these assets, the monkey is on the taxpayer’s back, and the banks have been completely bailed out of the consequences of their greed and poor management risk decisions.

This is one of the worst ideas with respect to taxpayers, and I believe we placed the US Government in place to protect us.

Change the deferred shares into common shares

This is the idea being touted today by the press, and Citigroup (this should raise a red flag by itself.)

The proposal is to convert enough government owned preferred shares into common shares so that the government ends up owning 40% of Citigroup – enough to make the government a major player in the bank, but not enough to control the bank.  You see that the value of all common shares today is $10B, and it wouldn’t take much conversion of the $45B to get to 40% ownership.

I believe the reader can see why Citigroup would favor this proposal – it retains control.

Tonight’s Dinner Conversation…..

What would you do to solve the insolvency problem plaguing the nation’s big banks????

Here are the last numbers:
Dow Jones 30 Industrial – 7114 (down 251 points) – EVEN MORE UGLY
10 Year Treasury Bond – 2.78% (up 0.01%)
Euro – $1.2695
Gold – $995 (down $7)
Oil – $38.44 (down $1.59)
Gasoline – $1.04 (down $0.03)