My Diary 427 --- LEH Short Cover, AIG Bail-out and FOMC Decision

My thoughts on the LEH Short Cover, AIG Bail-out and FOMC Decision

September 17, 2008

Some quick thought here

This is not a good time to be an investment banker and also bad time to drink Chinese Branded milk and yogurt….Will you dare to take some?....All are driven by greed.  With greed cycles on Wall Street come and go in 20 year durations, I still think there is an even bigger Jumbo Whale out there (otherwise known as a Black Swan) and it will be a Tsunami in its effect. The US has very little reserves left. Euro is in trouble too. Saviors are Russia and our Great China, mark my words.

LEH Short Cover --- I believe the rebounce of HSI in the morning session will be short-lived. As noted by the GS notice regarding LEH-PB orders, Lehman would have had quite a bit of borrow outstanding vs collateral. With chapter 11, that would trigger an event which results in Lehman being unable to return borrow, that collateral being liquidated and then used to buy back stock. That will provide some buy interest today. I would suggest the same strategy ---Sell or Short on Rebounce.

AIG case --- As I discussed, this is a much bigger animal than LEH. Fed did the right thing to take 80% stake of AIG in exchange of $85bn loan. The action immediately stabilize the credit market (See the retreat of HY and IG spread ~30-50bp overnight) and should be seen as a necessary action to stop the financial asset price deflation.

But what is the bigger implication to financial markets? Put it simply, let us assume that AIG is not the only mess out there. What are the choices? Politically and economically the equity injections can only come from the government and the US govt did that with savings and loan fiasco in the 1980s. In other words, there is always going to be moral hazard in financial institutions with the citizen ultimately picking up the tab in taxes.

My real concern is the linkage to the real market and if this continues, we can have a 1929 crash again if people get really scared: probability is greater than 50% I would say.

My other doubt is that although circumstances are not always the same and perhaps rationales are different between AIG and Lehman, but I just see logical inconsistencies in public policy at a very bad time, signaling to me that the guys in policy role are bewildered.

FOMC Decision--- the Fed left rates unchanged and the Statement shifted to fully neutral by unanimous vote and showed considerable toning down of the inflation-related comments. In my eyes, the damage to financial system begs a comment on how much that degrades growth /demand. This outcome echoes the smaller than expected December cut which was followed by a big liquidity injection announcement and suggests the Fed is comfortable some deal will be brokered for AIG.

Interestingly, the Fed's economic view remains more upbeat than the markets are. But with the US unemployment continuing to rise (7% in 09?) and a lower core PCE , there’s scope for Fed to cut rates further to 1% on top of probable further enhancement of various liquidity measures and possible bailouts.

FOMC Statement

Release Date: September 16, 2008

The Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

Strains in financial markets have increased significantly and labor markets have weakened further. Economic growth appears to have slowed recently, partly reflecting a softening of household spending. Tight credit conditions, the ongoing housing contraction, and some slowing in export growth are likely to weigh on economic growth over the next few quarters. Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee. The Committee will monitor economic and financial developments carefully and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh. Ms. Cumming voted as the alternate for Timothy F. Geithner.