Dow Industrial Component AIG Getting a Share-Cut

Probably the most overlooked story of the day is the implosion of insurance giant AIG. The probable reason for this is their exposure to mortgage related insurance AND their CDS exposure to failures in the corporate bonds markets.

There are rumours swirling of some major failures that are imminent. And the Fed and Treasury cannot backstop them all.

Reuters
AIG shares fall almost 30 percent on mortgage worries
September 12, 1:33 pm ET

NEW YORK (Reuters) - Shares of American International Group Inc fell almost 30 percent on Friday as investors grew increasingly concerned that its large exposure to mortgages is backing it into a corner. (That's not a corner, that's the edge of a cliff - Jesse)

The large global insurer, a component of the 30-stock Dow Jones Industrial Average index saw its shares fall as low as $12.40 in trading on the New York Stock Exchange, 29 percent off the prior's day close, before easing back to $12.53.

The stock has fallen more than 70 percent since it earlier this year warned investors that it could be hit by large, unrealized losses on credit default swaps it wrote to guarantee securities linked to subprime mortgages.

Since, the insurer has taken write-downs on these investments totaling about $25 billion, leaving it in the red by a cumulative $18 billion over the past three quarters.

"We attribute this (the share fall) to concerns about AIG's ability to shed its troubled mortgage-related assets and we expect the shares to remain volatile as investors await news from the company," said Standard & Poor's analyst Catherine Seifert, in a research note on Friday.

Citigroup analyst Joshua Shanker, in a research note, said he was cutting his target price for the stock to $25.50 a share from $40, citing marketplace fears over the insurer's financial condition. (Is this the same Citigroup analyst that had buy ratings all the way down on Fannie? Speaking of ratings, did you know that not one analyst has had a sell on LEH, even now? - Jesse)

Will the Fed Cut Rates Next Week?

Our bias had been that the Fed will do nothing until next year, just holding rates steady and tossing the markets an occasional jawbone.

But there is a good case to be made for a 25 basis point rate cut when the Fed meets next week on Tuesday 16 September. We now make the odds 55-45 for a cut.

How come?

The Fed has been given a short term gift by the dollar rally and commodities smackdown. Whatever the actual inflation rate may be, and we think its much higher than the official statistics allow, the perception is that inflation is waning because of the price drops in materials, especially oil. So they have more latitude for a cut than they had say in early July when all this started. And the bonds have rallied comfortably. A much stronger dollar is going to start dampening exports, which is the only thing the real economy has going for it lately.

There is a strong case to be made that the economic outlook has worsened in the jobs reports and unemployment levels. The credit crisis is also becoming more of a problem for the non-marquee financial names. The Fed needs to steepen the rate curve and a lower short end would be a little extra vigorish for the boys.

Lastly, this is probably the last chance the Fed will have to cut this year with a comfortable margin ahead of the November elections. The October meeting is just about a week beforehand and the Fed will be sensitive to accusations of political favoritism, especially if the polls are close. The Fed is many things, and among them it is a self-perpetuating bureaucracy.

The Fed and Treasury have been heavily targeting their liquidity adds to financial institutions with insolvency problems because of illiquid debt. The problem is that the write offs are coming too slowly because of a preoccupation with bonuses and stock prices, so the 'trickle down' to the real economy is not happening and credit flows are seizing again. A rate cut will be viewed as relief for the whole economy and not just the elites of the Street.

The case against a rate cut is twofold. First, there could be some concern about scaring the markets. We think a 25 bp cut spun as a "one and done" for 2008 is no problem there.

The other negative is a little more pointed. A stronger dollar encourages inflows of financial investments, which could be a factor in the desire of Wall Street banks to recapitalize. The Fed would probably like to keep the dollar away from that breakdown level it was bouncing along earlier this year.

The question now is how resilient will the dollar be? Can it hold its rally? Can the Fed cut rates and maintain the illusion that the US will be coming out of its problems first among developed nations? The answer here is similar to the first difficulty. The spun "one and done" can work to dampen fears for the dollar as well as the equity markets.

So there it is. Let's see what happens with Lehman over the weekend and the FOMC decision on Tuesday.

China Seeks to Reduce Its Exposure to Dollar Assets

Japan and India are already on this trend.

Is this a little nag from China ahead of next week's FOMC meeting?

Don't they realize that the Bankers' motto is 'what does not kill them makes us stronger' to paraphrase Nietzsche?

China may cut its dollar holdings
China Daily
2008-09-12 07:32

China, which holds a fifth of its currency reserves in Fannie Mae and Freddie Mac debt, may cut the portion held in US dollars, according to China International Capital Corp (CICC), one of the nation's biggest investment banks.

The US government this week seized control of the two mortgage-finance companies, which account for almost half of the home-loan market in the world's biggest economy, to prevent defaults from crippling them. China holds up to $400 billion in the two firms' debt, CICC Chief Economist Ha Jiming said in a report Thursday.

"The crisis has made Chinese officials realize it's a bad idea to put all their eggs in one basket," wrote Hong Kong-based Ha. "This will likely lead to greater diversification of foreign exchange reserve investments."

China held $447.5 billion of US agency bonds as of June 2008, according to the CICC calculations using disclosures by the US Treasury. It is likely to reduce the portion of reserves in dollar assets from the current 60 percent by purchasing more non-dollar assets with new reserves, he said.

Countries in Asia have stockpiled foreign exchange reserves since the 1997-98 financial crisis to act as a cushion against a run on their exchange rates. That in turn has increased pressure on policymakers to ensure higher returns from more than $4 trillion in assets.

China will expand its investments in corporate bonds and equities, according to Ha. Treasury and agency bonds account for 50 percent and 40 percent of total dollar assets held by the central bank, he wrote.

Why the Sudden Imperative to Promote a Deal for Lehman?

Three possibilities.

As suspected, customers are pulling their business, putting Lehman into a death spiral that will not wait until a major asset sale in October. Even the pressure from the Fed to maintain credit lines cannot generate business revenue, and that pressure becomes more difficult to maintain as the need for the lines increases. Once the death spiral starts it takes more than rumours to stop it.

Its also very possible that someone forced the Fed's and Treasury's hand. If one is in negotiations for a sale where price is a serious stumbling block in talks that have been going for many weeks, why set an artificial deadline for a firm deal that is only days way?

It appears that the price of the deal was deteriorating, so it would look like a seller was forcing the issue with a kamikaze negotiating maneuver. The plummeting stock price causes top employees to start leaving, and besides working capital the prime asset of an investment bank is its people.

Or it could be a potential buyer who feels they have nothing to lose trying to force Hank to throw down on a sweetener, threatening to take down either a subsidized deal or deliver a serious hit to the US financial system. Is Lehman speaking seriously with any non-US banks especially the Canary Wharf crowd? Would they-who-must-not-be-named do their own guy Hank this way? Hard to think Ken Lewis would play this card but who can say?

Hardball dealing no matter how one looks at it, but what else would be expected from the 'sell your mother for an eighth' crowd?

Can you imagine what will happen to the financial sector if Monday arrives and there is no tangible backing from the Treasury and no indication of a deal?

Postscript: The insightful and ebullient Yves Smith at Naked Capitalism proffers the idea that a more politically palatable backstop might be crafted through the FHLB. That is worth watching if a deal is announced.


Fortune
Lehman in the red zone
By Roddy Boyd
September 11, 2008: 6:56 PM EDT

...Meanwhile, long-time Lehman customers at four high-profile hedge funds told FORTUNE that they have sharply curtailed their trading with the firm.

One general partner at a $4 billion bond fund said that he is only doing trades that settle "next-day," or overnight, and now has no longer term counter-party risk with Lehman.

Customers' refusing to engage in longer-term derivative trades, if it becomes a trend, is problematic indeed for Lehman since derivative contracts are one of the last high-margin areas of trading. The profits from trading most bonds are measured in basis points and commissions from stock trading are pennies per share.

Among Lehman's many problems is the threat of possible multi-step ratings downgrades from the three major ratings agencies -- and all that entails for the costs of a financing-driven, narrow-margin business.

The fear among traders is best expressed in the rising price of Lehman credit default swaps. Traders at hedge funds and rival investment banks have pushed the price of insuring a $10 million block of Lehman debt to extremely high levels...