The New Year has begun with what I feared most for U.S. stocks--a huge new wave of analyst downgrades, especially in financial stocks, due to the ongoing credit crisis. The latest shoe to drop is from State Street Corporation, which manages $2 trillion for pension funds and other institutional investors. State Street announced on Thursday that it is setting aside $618 million to cover legal claims stemming from its investments in subprime securities, especially Collateralized Debt Obligations (CDOs) and Structured Investment Vehicles (SIVs). So, unlike Legg Mason and SEI, which have stepped up to the plate and bought back controversial money market investment, like SIVs, State Street basically is refusing to settle and is saying, "Sue me."
In addition, Lehman Brothers, which paid Jeb Bush as a consultant (and effectively ruined his future political career), sold the State of Florida the controversial SIVs that are anticipated to lose between $900 million to $2.3 billion is also refusing to settle. Last month, a town in Australia that lost 84% in CDOs is suing Lehman Brothers. In other words, lawsuits for losing money in money market investments (like CDOs and SIVs) are just starting and will likely persist for years.
The next big wave of Wall Street layoffs will likely come from Citigroup, which was responsible for originating about half of all SIVs extant. These SIVs are a kinky form of commercial paper that bets on up to one-year yield-curve spreads that have incurred excessive risks by betting on yield differentials tied to short-term mortgages. Although the new chairman of Citigroup did the right thing by putting these "off balance sheet SIVs" back on its books at a whopping $49 billion cost, this depleted the bank's capital, so layoffs are inevitable. In the end, I expect Citigroup will be broken into pieces and eventually be a shell of its former self.
Since institutional investors don't intend to lose the principal on their "safe" money market investments, there will likely be wave after wave of litigation against Lehman Brothers, State Street and other Wall Street firms that refuse to settle or buy back their controversial securities.
Central banks have already attacked the problems associated with subprime mortgages, CDOs and SIVs by adding one trillion dollars of liquidity, but the problem has simply gone from bad to worse. Last week, the Fed increased the size of its special liquidity auctions to help the banking industry, but it is uncertain whether these auctions will resolve interbank lending problems, since most banks do not seem to trust each other. Specifically, Fed President Jeffery Lacker (from the Richmond Federal Reserve Bank) stated in a speech to the Charlotte Chamber of Commerce last month, "It's not clear that this facility will address fundamental issues in inter-bank markets such as constraints on balance sheets, the need to raise capital and, importantly, concerns about counterparty risks." Translated from Fedspeak, the Fed is essentially up a creek without a paddle.
Not only is the credit crisis negatively impacting business spending and manufacturing, but consumer spending on big-ticket items is also in trouble. New home sales are running at the slowest pace in 12 years, with over nine months of unsold inventory. Vehicle sales are also dismal. On Thursday, Autodata, which tracks vehicle sales, announced that only 16.1 million new vehicles were sold in 2007, the lowest total since 1998, when 15.8 million vehicles were sold. In December, Ford and GM posted 8.9% and 4.4% sales declines, respectively. Clearly high crude oil prices are curtailing the sales of SUVs and other vehicles that get low gas mileage.
Overall, with business spending contracting and consumer spending on big-ticket items at 9- to 12-year lows, the U.S. economy is clearly on the verge of a recession. In fact, many states, such as California and Florida, are already characterized by rising unemployment and are already in a recession. As a result, the Fed must act fast. I firmly believe that the Fed cannot wait until its next meeting to cut interest rates. But this is good news for us. A sinking dollar works in our favor. Due to weak U.S. economic growth, the U.S. dollar has already given back much of its gains since October. Additionally, emerging economies, such as Brazil, China, Israel and Russia, continue to post steady currency gains relative to the U.S. dollar.
