Tuesday, November 27, 2007

Volatility Remains High

As expected, the Citi news lit a fire under the stock market on Tuesday even though C itself didn't really get a lot of attention. C opened up about 3.5% but promptly dropped back to even before closing up about 2% on the day. That didn't stop the rest of the market from partying with the banks and brokers faring the best on the day. The techs were at the party, too, with the NDX up over 2%.

...A couple of comments have emerged on C that we thought worth sharing in case you hadn't heard them. The first is that the 11% rate on the convertible bond represents "junk" status. Second, why did C have to go to a foreign government to get financing? Or, why did it need financing at all? Our reading indicated that the interest paid to foreign entities is Not deductible??? Third, some thought that the loan was to continue paying the dividend. The question exists, "Why not cut the dividend instead of paying 11% interest? ...

The 200 plus point move in the Dow didn't come without some volatility. The Dow jumped 100 points at the open and by early afternoon had zigzagged its way up to a gain of about 250. At that point sellers took it down so that it was only up about 100 and then it ran up into the close, up 215. This is the kind of market that drives bulls and bears crazy due to the extreme volatility.

After the market closed, Wells Fargo announced a loan loss provision. These news items are so common that the market seems not to even care anymore. But, a steady drum beat of negative hits to earnings by some of the leading banks and mortgage companies will take its toll eventually, if not sooner. The Wells Fargo item has a bit of a twist, that being they will be trying to sell some of their poor performing assets. That could sting a little. Wells Fargo only thinks the sting will be $1.4 billion. What's a 14 with 8 zeroes worth these days???

Anyway, the Update has been expecting a bit of a bounce from the lows due to the persistent nature of the market holding above the August lows. The players seem to be respecting that support line for now. Our thought is that the volatility now is due to a possible turn in direction from down to up. We do use the word possible because the market has not proved that it will go up, or if it does, how far it wants to go. It is weak and any selling at all will have a cascade effect with fear driving sellers into the market.

The news on home prices and consumer confidence should have dampened the overall bullish spirit on Wall Street but the party was on and nothing seemed to distract it. The other item was lower oil prices. We think that the oil price has tracked pretty well with the stock market for a long time so today's $3 decline would seem to be bearish for stocks. We could make the argument that that oil prices have lagged the decline in stocks so it had some makeup work to do.

Speaking of makeup work, we thought we'd review the homework assignment from our last post. Your first question is something new to us, too. What is a VIE? Well, in short, it's short for "variable interest entity". Our take on the VIE is that it is a way for a company, like a bank, to report on their SIV's, you remember those, the Structured Investment Vehicles.

A bank sets up a SIV in order to reduce its capital requirements. By setting up a SIV, the assets in the SIV do Not show up on the bank's balance sheet and do not need to have capital backing them, interesting concept. Meanwhile, the SIV can go about its business of borrowing money in the CP market (Commercial Paper) and buying longer dated obligations like subprime mortgages.

In the reading material, the author speaks about CDO's (Collateralized Debt Obligations, if you want to know) and how they were the big problem. Well, CDO's can have a variety of assets in them including subprime mortgages. Since the SIV is not a publicly held company it doesn't have to report its earnings or losses to the SEC and the bank that owns it only has to provide some footnote info on the VIE (the SIV and its assets).

There is an accounting rule that says that banks need to report the Maximum losses from their VIEs. The banks can report the Maximum loss but not the Actual loss. And, the banks can downplay the number as it's the maximum and will never materialize. However, as we found out this year, the actual losses can be quite substantial. The article says:

Take a look at Citigroup's second quarter filing, posted Aug. 3, which was well into the summer credit meltdown. In it, the bank said actual losses from its unconsolidated VIEs, which included $75 billion of CDOs, were "not expected to be material." It has since estimated losses could be between $8 billion and $11 billion (which is most definitely material).

More tomorrow...

FSI: 101.93 (not a particularly robust move on a day like Tuesday)


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