Fed Chairman Ben Bernanke made a strong showing before the House Financial Services Committee. Mr.Bernanke gave a well-thought-out and carefully-worded testimony on Capital Hill. Although he acknowledged that the worst of the financial crisis may have passed, the U.S. economy still faces significant headwinds. Because of this the Fed continue to maintain an accommodative interest rate policy. The U.S. treasury market reacted sharply to Mr. Bernanke's testimony as prices of the ten-year treasury note and the 30-year government bond rose sharply on the Fed Chairman's tame inflation outlook. The equity market rallied (again) as accommodative Fed policy is traditionally good for business. However, are the markets reacting in a rational manner or are market participants looking to the future through rose colored glasses?
Prices of long-dated treasuries rallied on Mr. Bernanke's testimony that inflation will be held down by labor market dislocations. However, when the labor market does improve, long-term rates could rise. It is quite possible that the bond market is being overly optimistic that inflation pressures will be muted. Of course it could be managing its expectations that the economy is in for a modest and protracted recovery.
The equity markets are expressing a different view. The equity market is view a moderation of economic decline as a sign that a sharp economic recovery is around the corner. However, history shows us that the equity markets are both overly optimistic and overly pessimistic. This is why we have bubbles and corrections. In my opinion it is the equity market which is wearing the rose colored spectacles. The economy is stabilizing and will eventually experience sustained growth, but it will have to do so without the turbocharging effects of cheap, easy-to-obtain leverage. This is your grandfather's economy. at least for now.
It turns out that CIT's bailout was no such thing. The $3 billion emergency financing, besides being insufficient in the long term, comes with significant strings attached. The deal hinges on bondholders agreeing to accepting less than 100 cents on the dollar in the form of common equity in exchange for their bonds.
The proposed exchange offers 82.5 cents on the dollar, in common stock, to holders of the floating-rate CIT bonds due 8/15/09. Holders of, as yet unnamed, longer-dated bonds would receive 80 cents on the dollar in the form of CIT common. How far out are these other maturities? Probably out through 2010 as that is CIT immediate concern.
To execute the exchange, CIT needs 90& of affected bondholders to agree to the exchange. If 90& of these bondholders agree, all holders of the affected bonds will be awarded common stock at the aforementioned ratios whether or not the want common. Unless one wishes to be an equity investors in CIT, one should sell their CIT bonds and reinvest the cash. What happens if the deal is not approved by bondholders? A bankruptcy filing would be the most likely outcome.
I have had many questions regarding GE Capital. GECC does have issues with poorly-performing loans and a challenged business environment, but it has issued TLGP bonds which are backed by the FDIC and have an implied backing by its parent, GE. I believe that GE will continue to support GECC as to not do so would incur the wrath of the government which would be on the hook for $48 billion of GECC TLGP bonds should GE Capital default. I cannot see the government doling out $48 billion when deep-pocket GE sits idly by. I am sure Sheila Bair and Tim Geithner would be on the phone to GE CEO Jeff Immelt "suggesting" he write a check.
I believe GECC senior notes to by a buy for accounts who can tolerate continued volatility.
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