Agora Financial’s Rude Awakening

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• The financial crisis: The end of the beginning of the end?
• Risking seductive investment opportunities over the fetive season,
• 10 days left to get in on the Reserve, the most important vote of 2007 and more… 

Joel Bowman, counting votes in the Middle East, reports…

For a Muslim country, the UAE certainly knows how to celebrate the Christmas
season. Maybe that’s because a large portion of those taking part in the
festivities are expatriate workers…Or maybe it’s because Christmas also
happens to fall right around the Muslim celebration of Eid Al Adfa.

In any case, there’s been no shortage of partygoers strolling the trendy
boardwalk of Dubai’s famed Marina over the past week.

The other night, your non-Muslim, non-Christian editor was invited to enjoy a
few celebratory cocktails at a fancy restaurant overlooking this aquatic
jewel in Dubai’s crown.

The deep blue Arabian waters wind in and around a multitude of designer
stores and “in-scene” eateries. Women and men in traditional abayas and
dishdashas stroll, arm-not-in-arm, through the moonlit markets while their
children play in the many fountains along the path. Wealthy diners toss
Bentley and Porsche keys to the valets. Wealthier diners moor their luxury
yachts and cruisers before taking their table.

Being without a boat of our own (and barely renting a pathetic 4-cylinder
automobile) we were understandably awed by the vast collection of “Arabian
toys.”

Unable to choose a favorite of our own, we decided to poll the other guests
at our table.

“That big double-decker one has a nice area up front for sun bathing,”
remarked one female diner.

“Nah,” retorted another, a fellow. “You’ve gotta take that speedboat. Imagine
the wakeboarding you could do off the back of that baby!”

Choosing a favorite boat on the Dubai Marina, it seems to us, would be a bit
like choosing, say, a favorite Rude column for the past year. It’s an
unenviable task, to be sure. You can imagine, therefore, the difficulty
you’re editors are having trying to decide a “Best of ‘07″ selection for next
week…especially as contributors seem intent on voting for their own
creations.

Therefore, we turn to you, Rude reader, and implore your help. When you have
a second, kindly take a look back through the Rude body of work for 2007 and
select your favorite column. Then, simply send along your vote to the address
at the bottom of this email and tune in for the results next week.

But before you cast your vote, be sure to take a gander at Eric’s column for
today. It’s a late entry, to be sure, but it’s certainly good enough to
ruffle some feathers on the current leader board.

Enjoy…

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A Seductive Temptation
By Eric J. Fry

Financial stocks may not yet be a resounding “Buy,” but they have probably
become a less resounding “Sell.”

We issue this highly qualified forecast on the basis of poetic irony…and not
much else. Last week, Morgan Stanley analyst, Betsy Graseck, scorned the
shares of Citigroup as Morgan’s number one short sale recommendation for
2008. “We are pitching Citi as our top short idea for 2008,” Graseck declared
on December 12th. “We would be sellers on strength.” Graseck’s brazen
recommendation closely resembles hurling stones inside a glass house.

The glass House of Morgan, if we recall correctly, is a financial institution
that also owns toxic mortgage-backed securities (MBS). In fact, it is a
financial institution which, if memory serves, also took a multi-billion-
dollar writedown on the MBS littering its balance sheet. And doesn’t Morgan
Stanley share another ignominious connection with Citigroup? Didn’t Morgan
just receive a $5 billion bailout from the China Investment Corp. – a deal
that looks an awful like the Abu Dhabi Investment Authority’s $7.5 billion
bailout of Citigroup?

But let’s put aside Morgan’s hypocrisy for the moment so that we may examine
its irony. Morgan’s recommendation to sell short Citigroup shares (NYSE: C)
arrived on a day the stock closed almost 50% below its all-time high.
Throughout Citi’s slow-motion collapse of the last 12 months, Morgan
steadfastly maintained some version of a “buy” recommendation on the stock.
In fact, as the nearby chart illustrates, Morgan reiterated its favorable
forecast for Citi several times during the stock’s drop from $57 a share last
December.

If Morgan’s advice was so misguided during Citi’s collapse, would the Fates
and Furies of the financial markets permit Morgan’s advice to be timely and
accurate now? Not likely. To the contrary, Ms. Graseck’s “sell short”
recommendation feels an awful lot like a contrarian “Buy” signal.

As faithful readers of the Rude Awakening will recall, your editors sounded
an early and persistent alarm about the risks of owning financial stocks:

“Sell Countrywide Financial (NYSE: CFC)/Buy California Water Services (NYSE:
CWT),” we suggested in the October 3, 2006 edition of the Rude Awakening.

“Both companies conduct the bulk of their business in the Golden State.
Countrywide is the largest mortgage lender west of the Mississippi.
California Water is the largest water utility west of the Mississippi. But
the similarities end there. At 24 times forward earnings, CWT would not
likely dazzle any value investors. And yet, we would consider CWT a better
value than CFC, a stock that sells for a mere 8 times earnings. Why would we
shun the statistically cheap CFC in favor of the pricey CWT? In a word,
“drought” – a mortgage-lending drought, that is. As the housing bust
continues busting, the “E” component of CFC’s PE ratio will atrophy, if not
disappear entirely. The housing boom is over…and we suspect the bust will
last a very long time. Coincidentally, ‘a long time’ is also the likely
duration of demand for water in California.”

But the fact that we correctly anticipated the unfolding trauma in the
financial sector does not mean that we have any idea what will happen next.

We do not. We have no idea.

Nevertheless, if we were tempted to establish a bearish position on Citi at
its currently depressed price, Morgan’s “sell short” recommendation would
erase the temptation. In fact, Morgan’s recommendation has the look and feel
of a classic contrarian “buy” signal, especially because Morgan sounded its
bearish alarm only one day after Citi’s new Chief Executive, Vikram Pandit,
took charge.

And did he ever!…On December 13, Pandit promptly reversed the prior
management’s insistence that it would NOT take SIVs onto its own balance
sheet. [SIVs are entities that borrow short-term money in the commercial
paper market, then invest the proceeds in debt instruments like mortgages,
credit card receivables and collateralized debt obligations (CDOs). For many
years, Citigroup would operate SIVs to generate various fees, but would not
use any of its own balance sheet to finance the investment activities of the
SIVs. As such, the SIVs behaved very much like a direct subsidiary of
Citigroup, while remaining technically "off-balance-sheet"]. As recently as
November 5, a regulatory filing from Citi stated that it “will not take
actions that will require the company to consolidate the SIVs [onto its
balance sheet].”

Pandit’s surprising about-face will dump $49 billion of additional
liabilities onto Citi’s balance sheet, without the comfort of knowing what
the offsetting assets might actually be worth…or not worth. In a “normal”
world, this maneuver would have attracted no attention whatsoever, much less
front page headlines. But the normal world disappeared sometime last August.
So here’s the rub: the $49 billion of liabilities is known and certain; the
value of the offsetting assets is unknown and uncertain. Maybe the assets are
actually also worth $49 billion, but probably they are worth several billion
dollars less, which would mean that Citi would be taking more multi-billion
writedowns in the future.

So how are multi-billion writedowns a “buy” signal, you may be wondering?

Well, maybe they aren’t. Maybe Ms. Graseck is right. But we think we see in
Citi’s mea culpa the beginnings of a genuine recovery – the beginnings of
what professional investors and economists would call the “market-clearing
process.”

By taking this stuff onto its balance sheet – like HSBC and several other
smaller banks had already done – Citi embraces the free-market dynamics that
will begin to establish real-world prices for the distressed MBS that are
causing multi-billion writedowns. And by beginning this process, the MBS
market can resume attracting real-world investors, rather than government
price-fixers.

Pandit’s decision to assume full balance sheet responsibility for Citi’s SIVs
also signals to the world’s financial markets that the new sheriff at Citi
bears little resemblance to the old one. The new sheriff seems to prefer
free-market remedies to governmental bailouts, even when his company would be
the primary “bailout-ee.”

Why would Pandit shun governmental meddling to “do it himself?” Presumably
because he realizes the sooner the MBS market finds real-world pricing, the
sooner real-world investors will return to the marketplace…and the sooner
Citi can return to the profitable business of borrowing short and lending
long…until the next epic credit disaster.

We would not dare to suggest that the credit crisis has passed, or that Citi
will emerge unscathed. But we would suggest that we may have reached the end
of the beginning of the crisis. And if the beginning has ended, we would not
be surprised to see a major short-covering rally to celebrate the event,
especially if that rally were to coincide with Chanukah, Christmas and
Kwanza.

But remember folks; we’re just guessing here. The stock market never consults
our opinion before the opening bell. So financial stocks might continue
tumbling, no matter how enticing and delicious the idea might be to buy Citi
after Morgan calls it a “short sale.”

We confess that we have managed to seduce ourselves with the temptation to
buy financial stocks “for a trade.” But like all the other seductive
temptations that drift through our consciousness, we will resist it…probably.

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Rude Endnote: As you’re casting the most important vote of the year, please
remind yourself of the reasons for your selection…and then remind us. A few
sentences on why you chose XYZ Rude for “Best in ‘07″ nomination will
suffice.

Cheers,

Joel Bowman
Rude Awakening