Wednesday, May 20, 2009

Changing Gears: Thoughts On Deflation/The Fed Minutes And What I Think BAC Is Worth

The Fed minutes leave no doubt in my mind that most of the members realize how crucial low rates are to our fragile economy. Higher rates would not only ruin the fed’s credibility but also destroy any hope for a recovery. Make no mistake if they have to choose between a weaker dollar and lower rates they only have one way to go. We can argue about the timing and degree of dollar destruction but fight the fed on rates in the near term at your own peril.

In a deflationary environment coupon clipping is a viable strategy. In other words if asset prices are going down, staying where you are isn’t such a bad thing and anything else is gravy.

Quantitative easing is attempting to punish savers but that doesn’t mean you have to play their game. Chasing risky assets that have run 30% or more is just that: chasing.

Now, on to BAC. Celebrate Dilution. At least that is how the bears will likely snort at the BAC deal and the other secondary placements.

But the glass is also half full.

Take the BAC example. Factoring in the dilution, applying the loss assumptions laid out under SCAP, the stock is worth $40. Once the stock is fully capitalized, with fears of insolvency and massive dilution past it, the stock will be able to realize that value.

The deal is clearly a win/win.

There are at least five other bullish elements to the BAC story from the point of view of the market:

1. A huge share overhang is removed.

2. A huge risk – ie backdoor nationalization under the CAP regime --for the financial sector is removed. (At least for now).

3. Clear evidence of massive cash availability + clear evidence of collapsing risk aversion.

4. Clear evidence of the restoration of functionality in private capital markets.

Let us recall that in February, Roubini and a whole slew of misinformed but influential commentators were competing to outdo themselves to see who could most rabidly call for the nationalization of the entire US banking system. For example, Dr. Doom literally recommended in a WSJ interview on February 21st that ALL US banks be “taken over all at once” since “six months from now, even firms that today look solvent are going to look insolvent.”

I wonder if any of these eschatological prophets of economic apocalypse might be feeling a bit silly right now?

The BAC deal, and the success of the other secondary offerings, are suggesting very strongly that the US financial crisis is essentially over. The patient has been stabilized and the healing process has begun.

More broadly, it is beginning to appear that variously giddy and manic depressive reports proclaiming the “death of capitalism” may, to borrow a phrase from Mark Twain, have been greatly exaggerated.

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