Black November Begins With US Federal Reserve’s $41b Citigroup Bailout

Anyone under the impression that the carnage in the credit market is fully priced into financial stocks had better take a deep breath before reading on. Remember to breathe.

How will the ASX react to yesterday’s 362 point, 2.6% decline on the Dow? We think it will highlight the growing divergence between financial shares and resource shares. Granted, the difference is already pretty clear. One type of firm makes money off of money. The other makes money from “stuff.” It’s not complicated.

But October came and went without the dreaded “Red” trading days that headline writers covet. That’s okay. Black November is off to a good start.

By good we mean really bad. “It almost feels as if yesterday's action in the market was a dream and we woke up today to a stark reality – that we're not going to be getting rid of this significant, persistent and consistent downdraft in the financials for some time,” Peter Kenny, managing director at Knight Equity Markets, told Bloomberg.

But yesterday’s biggest news got the least attention. Little noticed and lightly reported in the aftermath of yesterday’s post-rate cut rout is this item: the Federal Reserve injected US$41 billion into the American financial system in three separate open market operations yesterday.

So what? What’s US$41 billion between central bank cronies and their banking friends?

That US$41 billion in one day is the second largest amount on record. And no single day of the credit crisis in August matched it. The previous record was set on September 19th, 2001, when the Fed pumped US$50 billion into the US markets in post 9-11 trading. So why, you may be wondering, did the Fed need to inject so much liquid courage into the market after cutting rates the day before?

The answer may lie with Citigroup (NYSE:C), an American financial stock. Citigroup appears to be the latest casualty in the slow-motion collapse of the asset-backed commercial paper market. That’s the market where bundles of securitised assets (equipment, loans, credit card receivables) are used as collateral for loans. That market is the primary source of funding for certain financial institutions.

Trouble is, the asset-backed commercial paper market has fallen by 26% since the beginning of the credit crisis in August. “The collapse of the market,” writes Rex Nutting at CBS Marketwatch, “has prompted mortgage companies and others who relied on the commercial paper market to seek alternative sources of funding, mainly by tapping existing credit lines at large banks. The banks, in turn, have sought alternative funding for their special investment vehicles…Citigroup's shares were lower on Thursday on reports it needed to raise US$30 billion in capital, perhaps by cutting the dividend.”

Are you still with us? It’s time for a short course in forensic finance. First, the crashing US house market leads to falling prices for mortgage-backed securities. Next, CDOs that contain mortgage-backed securities begin to fall. Indexes which track the CDO and asset-baked security market reflect these falling values. Ratings agencies get in the game by re-rating AA and AAA bonds…downward.

That last phase—the re-rating of asset-backed commercial paper—happened in mid-October. Only now is it filtering down to real-world consequences. Faced with falling asset values and a tight credit market, Citigroup, perhaps, turned to the only source of funding left in the market yesterday: the Fed.

Will this chain of consequences lead to more collateral damage in financial stocks?

Tomorrow is Friday in America. It’s going to be black.

Dan Denning
The Daily Reckoning Australia

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