Not Business as Usual

I have had an idea for some time that the credit crisis would run deep and would have broad negative ramifications for future economic growth. Slowly, as I wrote last week, many are beginning to finally face the reality of a consumer-led slowdown/recession, corporate profit (and margin) vulnerability and an emerging deflationary spiral in many asset classes (e.g., in debt and in residential/non-residential properties).

With last night's announcement that one of the two Bobbsey Twins of unconscious credit creation, Citigroup (C - commentary - Cramer's Take), has turned to the Abu Dhabi Investment Authority for fresh capital in order to shore up its balance sheet and to offset an additional $11 billion of mark-to-market losses in it's collateralized debt obligation book in the current quarter, even the cheerleading permabulls have finally begun to admit to the implications of the credit problem. And when the cheerleaders no longer cheer under the pressure of downbeat news, we grow ever closer to the restoration of value in the markets. (See Dylan Ratigan's report on my expectations for a market snapback from last night's "Fast Money" broadcast.)

It should be noted that the magnitude of Citigroup's problems (and, by implication, the world's credit woes) is directly reflected to the generous terms and the dilution (about 11 cents in 2008) of the Abu Dhabi transaction, a convertible stock yielding 11% annually and at a mandatory conversion price of between $31.83 and $37.24 (exercisable between March 2010 and September 2011). In plain terms, the Citigroup convert is junk status, from both interest and convertibility features, and speaks to the aforementioned need for an injection of capital from this former banking titan. (Kudos to Meredith Whitney, CIBC's bank analyst, for her courageous analysis.) According to my back of the envelope analysis, the capital will lift the bank's tier one capital by about 55 basis points, to 7.50%.

The positive market take from the Citigroup transaction does not relate directly to Citigroup but rather, as I mentioned yesterday, opportunistic non-U.S. buyers that seem likely to accelerate their acquisition of our currency-depressed assets through year-end and into 2008. Cross-border merger and acquisition deals remain one of my six reasons for a potential year-end rally. For instance, besides the Abu Dhabi deal, yesterday, Philips (PHG - commentary - Cramer's Take) acquired lighting manufacturer Genlyte (GLYT - commentary - Cramer's Take) at a large premium, despite Genlyte's housing-centric business.

Though many have glibly disregarded the mounting headwinds and warnings, preferring to look myopically at the current economic issues as just another blip in an uptrend, we already have had some clear hints of what the future holds. Most noticeably, the message of the fixed-income markets remains clear: Yields -- the 10-year U.S. note dropped by over 15 basis points alone in yield on Monday -- suggest that, absent a broad-based fiscal Marshall Plan to deal with the credit mess and absent continued third-party capital infusions to the (multiplying) needy (of a financial institution kind), we are about to experience a large-scale financial failure and/or the economy is moving rapidly into a recession.

My guess for the next failure/bailout/capital infusion would be either Washington Mutual (WM - commentary - Cramer's Take) or Countrywide Financial (CFC - commentary - Cramer's Take).

While the market, as we move toward year-end, should have a number of positive influences -- I recently named six -- the fear of the unknown (especially of a credit kind) is dominating the market and is certainly trumping low sentiment readings and other potentially positive catalysts.

It is particularly disconcerting to think that Jim "El Capitan" Cramer might be right about the knuckleheads in Washington behaving more like a disparate flock of deer in the headlights with political agendas than exercising true leadership (especially of a business kind.

As I have written over the entirety of 2007, the transition from credit/debt accumulation to de-accumulation will be a painful process, leading to a degree of volatility that most market participants have rarely seen. As a measure of that volatility and proof-positive of the developing deflationary influences, just look at the REIT Index, which experienced the largest one-day drop (of about 5%) in history in Monday's trading.

If you must be involved in the market with no memory from day to day -- my refrain remains constant (to the point of redundancy) -- err on the conservative side in your trading and investing. Singles and doubles is the ticket. Or better yet, wait for the right pitch.

I recently wrote that this is the hardest stock market to navigate ever, and that applies for both pros and individual investors alike.

And I still mean it.

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At the time of publication, Kass and/or his funds were short C, although holdings can change at any time.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd.