US Dollar Weekly Chart with Commitments of Traders

Charts in the Babson Style for Week Ending 12 September 2008

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.