The leadership crisis at Citigroup Inc. (C) finally reached climax proportions late yesterday (Sunday) after the bank announced that embattled Chief Executive Officer Charles O. "Chuck" Prince III would retire.

Former Treasury Secretary Robert E. Rubin – chairman of the executive committee and a member of the board of directors – will serve as chairman of the board.

In addition, Sir Win Bischoff, Chairman of Citi Europe and a member of Citi’s Business Heads, Operating and Management Committees, will serve as acting CEO.

Prince, 57, has elected to “retire” as chairman and CEO, Citi said late yesterday. The Citigroup board has designated a special search committee to look for a new CEO.

Prince said that “we have made strong progress in our strategy for building for the future, evidenced in the momentum we have achieved in most of our businesses. Nevertheless, it is my judgment that given the size of the recent losses in our mortgage-backed securities business, the only honorable course for me to take as chief executive is to step down. This is what I advised the board.”

It was reported late last week that Prince had offered to step down, which is one explanation for why the big bank’s board of directors met over the weekend for an emergency meeting, according to published reports and sources familiar with the situation.

Just a week after New York-based Merrill Lynch & Co. ousted Stan O’Neal, Citigroup spokespeople late last week declined comments on a rash of newspaper and wire-service stories appearing across the United States that said that Prince would step down.

"We are completely declining to comment," Leah Johnson, a Citigroup spokeswoman and member of the New York-based company’s management committee, said yesterday.
But that didn’t lessen the speculation.

"This might become a weekly occurrence, getting rid of a Wall Street CEO," James Ellman, who manages about $200 million as president of Seacliff Capital in San Francisco, told Bloomberg News last week.

The bank was believed "highly likely" to name Robert E. Rubin, the former Treasury Secretary under President Bill Clinton, as its interim chairman today, the New York Times said, citing an unidentified person briefed on the situation. The newspaper said both Rubin and Christina Pretto, a Citigroup spokeswoman, declined to comment.

The Number 1 U.S. bank by assets reported $6.5 billion in write-downs and losses in the third quarter, casting doubt on Prince’s ability to run the banking concern.

Stockholder Pressure

Richard Bove, a Punk Ziegel & Co. analyst who is one of the best banking analysts in the country, said on Friday that Citigroup’s board “may have simply reached the point where they can’t take the pressure from stockholders and they have to remove him.”

The Securities and Exchange Commission is looking into how Citigroup accounted for certain transactions in a banking- industry rescue plan, the Journal said Friday. Specifically, the SEC is studying whether Citi improperly accounted for an estimated $80 billion in structured investment vehicles, the newspaper said.

The result of the review, still in early stages, could include no action or a referral to the SEC’s enforcement division, the Journal said.
Either way you slice it, Citigroup Inc. (C) is in for a world of pain.

Facing a possible $30 billion capital shortfall, the company may be forced to cut its dividend or sell assets, said banking analysts Meredith A. Whitney and Carla Krawiec of CIBC World Markets, in a report released Wednesday night.

If Citi makes either move it’s likely that shareholders would head for the nearest exist sign.

Exodus Already Under Way?

"Since 2006, Citigroup has made $26 billion in acquisitions, taken over $6 billion in recent charges, and increased its dividend against a backdrop off almost no net income growth," Whitney and Krawiec wrote in their research report, downgrading the company’s stock to an "Underperform."

"We believe the stock will be under significant pressure, and could trade in the low $30s," the report also stated.

Citi Currently a Lightning Rod of Controversy

That report intensified resignation calls for the ouster of Prince, especially after Merrill Lynch & Co. Inc. (MER) CEO E. Stanley "Stan" O’Neal was ousted earlier last week.

Citigroup posted a 57% drop in third-quarter earnings. Compounding the problem was where those losses came from: Citi’s fixed-income business, usually a strong suit for the banking-and-finance concern, was a big part of the earnings decline – and included a loss of $1.3 billion related to problems with mortgage-backed securities.

Trying to regain footing after the credit rout slammed lenders around the world, Citigroup, Bank of America Corp. (BAC) and J.P. Morgan Chase & Co. (JPM) agreed to start a fund that would enhance the liquidity of the asset-backed commercial paper (ABCP) market, as well as medium-term notes issued by structured investment vehicles (SIVs). The plan has met with substantial controversy, but the goal of the fund would be to pump liquidity back into the commercial paper markets. Unfortunately, other banks haven’t warmed up to the idea because they don’t trust the assets backing the loans.

A sale of Citigroup assets only legitimizes those fears.

News and Related Story Links:

• Citigroup Press Release:
  Robert E. Rubin to Serve as Chairman of the Board of Citi.

• Bloomberg News:
  Citigroup Doesn’t Deny Prince Exit as Shares Drop 31%.

• MarketWatch.com:
  Citi Board Gathering for Emergency Meeting: WSJ

• Money Morning News:
  Investors Bolt From Citigroup in Light of Suggested Dividend Cut or Asset Sale.

• New York Times:
  Analyst Raises Doubts About Citigroup Dividend

• Reuters:
  Citigroup Net Slides 57% on Write-Downs, Losses.

• Money Morning:
  O’Neal Finally Out at Merrill Lynch

• Money Morning:
  Banks Create Fund to Help to Fight Woeful Credit Market

• Financial News:
  Banks Steer Clear of Super-Fund

• Money Morning:
  Dropping Housing Prices, Rising Foreclosures Could Confirm Our Worst Fears.

• Money Morning:
  Banks Create Fund to Help to Fight Woeful Credit Market.

• Money Morning:
  Citigroup and UBS Brace For Losses, but Dow Jones Sets Record Above 14,000.

• USA Today:
  Investors Cheer UBS, Citigroup Write-Downs.

• Bloomberg:
  Merrill Lynch Reports Loss on $8.4 Billion Write-down.

• Money Morning News Report:
  Merrill Lynch Ousts CEO O’Neal.

• Money Morning:
  The Merrill Lynch "Surprise" Fuels More Subprime Uncertainty.

• Forbes.com:
  Merrill Needs a Plan (And a New Leader).

• Bloomberg News:
  Merrill Lynch’s O’Neal Departs With $161.5 Million Plus Perks.

• CNNMoney.com:
  Merrill Lynch’s CEO To Depart Amid Board Pressure: Reports.

• CNNMoney.com:
  Merrill Said to Face More Write-downs.

• Bloomberg News:
  O’Neal Ouster Makes Mess of Maternal Merrill Lynch.

• Money Morning:
  Avoid the ‘Resurgent’ Homebuilding Sector and Go Global for Profits.

• Money Morning:
  Housing Market Down For the Count, According to Industry Experts.

• Forbes.com:
  More Merrill Write-downs Expected.

Some days you’re the bug and some days you’re the windshield.

Yesterday (Tuesday), there were a whole lot of bugs in the guise of the short-sellers who got squashed on Ben Bernanke’s windshield; they covered their positions at any cost and then limped into the hills to hide.

Trading volume was huge and the rise of the major indices meteoric. But what’s not clear is whether this stunning rally is strong enough to go the full nine innings.

History suggests that Fed-related ‘market bottoms,’ or low points, can serve as the launching pads for powerful rallies. So I won’t rule out the possibility that yesterday’s big stock-price rally – which included the biggest one-day gain by the Dow Jones Industrial Average in nearly five years – will turn into a high-scoring affair.

[For a full news report on yesterday’s Federal Reserve decision, and the surge in stock prices that resulted, click here. For some investment ideas from Martin Hutchinson, our director of global investing research, based on the Fed’s decision yesterday, please click here.]

Even so, I find that I’ve got a bit of a cynical feeling about yesterday’s market action, if for no other reason than similar rate cuts did essentially nothing for stocks in 2001 and 2002 under very similar “bubble-like” conditions.

Nor did big rate cuts help Japan much, either, not even when that country’s central bank slashed interest rates all the way back – to 1%  – and that country fell into a 15-year recession. Talk about a shutout!

Therefore, the question in my mind – and the one that I think most people need to be asking themselves over the next couple of days – is this: What does the Fed know about how bad things really are that Bernanke had to go to the central bank’s bullpen, and pull out a rate reduction of a full half a percentage point?

In other words, are we dealing with a bona fide slugger, a true legend-in-the-making, like “Hammerin’ Hank” Aaron? Or is our Fed chairman more of a likable, good-natured duffer like Bob Uecker?

Either way, I think Team Bernanke brought in the heavy artillery much earlier than seemed necessary, and perhaps wasted a shot in the process.

Here is the view from the bleachers, at least as I see it:

• One: The Fed has spent the past month injecting tens of billions of dollars in liquidity into the U.S. financial system just to help bail out a group of folks who could be the poster boys of subprime-mortgage mismanagement. There should already be a copious amount of liquidity out in the financial system, without having to also lower interest rates. Assuming this is true, there shouldn’t have been the need for such a dramatic cut this early in the game. That’s ‘Strike One.’
• Two: The job rolls are falling, gold is rising and oil traded at more than $80 a barrel last week – the first time it eclipsed that price level. Other commodities are up as much as 80% in the last five months. These are classic signs of inflation, and they aren’t going away. Against such inflationary pressures, a hefty rate cut is more like a Rip Sewell ‘Eephus’ pitch, than a Roger Clemens fastball. The rate reduction doesn’t help us much, and with the wrong timing, it may get ‘taken downtown’ for an inflation inducing grand-slammer. That’s ‘Strike Two.’
• Three: The dollar has fallen below the capital markets ‘Mendoza Line,’ and the greenback continued to fall today – even in the midst of the biggest single day U.S. stocks have enjoyed since October 2002. This makes the dollar an even-less appealing holding for overseas investors, and it may well have opened the door for our biggest debt-holders (China, Japan and Korea), to start dumping dollars, which would be catastrophic for this country’s economy on a variety of fronts. That’s … Juuuusssst a bit outside … ‘Ball One.’

What? No strike? Didn’t the ump “ring us up” with a called third strike?

Nope. As bad as a weaker dollar is in global terms, it’s actually great for investors who own what I like to call the “Global Titans.” You’ve heard me talk about these before. These are globally diversified companies, and most of them have nice businesses in Asia, and in China in particular, where the economy is growing at a 12% annual clip. They’re great stocks to hold anytime, but during periods of severe uncertainty (especially uncertainty caused by interest-rate stress), there’s almost nothing better to own on the equity side of the ledger.

An easy way to get in the game is to pick up the SPDR DJ Global Titans (DGT), which is traded both in Frankfurt and New York. It’s a quick way to snap up dividends and draw support from the world’s biggest brands at the same time.

All in all, I think yesterday’s rally was a gift.

On one hand, the Fed got its way. On the other, it highlighted just how fragile the U.S. economy is at a time when the global markets are actually gathering steam.

Batter up!

Related News and Story Links:

• Money Morning News: Bellwether Blue Chip Stocks Record Best Week Since April.
• Wikipedia: Rip Sewell and the Eephus Pitch.
• Baseballreference.com: Roger Clemens.
• MSNBC.COM: Wall Street Delighted by Aggressive Rate Cut.
• Wikipedia: The Mendoza Line.
• Wikipedia: Bob Uecker.
• Baseballreference.com: Bob Uecker.
• Baseballreference.com: Hank Aaron.

 
After weeks of water-cooler speculation, the U.S. central bank’s policymaking Federal Open Market Committee yesterday (Tuesday) slashed the benchmark Federal Funds rate by half a percentage point, to 4.75%. It was the first reduction in U.S. interest rates in four years.

This strategy – of sharply cutting interest rates every time the stock market, or the economy – skidded into a rough patch, used to be known, quite sardonically, as a “Greenspan Put,” in honor of former Federal Reserve Chairman Alan Greenspan.

The move itself will have made Jim Cramer, Larry Kudlow and many other stock traders very happy. The commensurate Louis Roederer Cristal/ Dom Pérignon champagne indicators will no doubt stage a strong sympathy rally this evening.

But I would argue that the rest of us should very seriously consider purchasing some “put” options.

Let me explain …

Rate Reduction Redux

As I said in my column yesterday, I believe that a rate reduction of this magnitude will touch off a resurgence in the U.S. economy – but with a cost, as I expect that we’ll see inflation begin its upward march.

However the text of the Fed’s statement, and some new data yesterday, raises a disquieting alternative possibility: Perhaps Fed Chairman Ben S. Bernanke knows something ‘bad’ about the U.S. economy, that the rest of us aren’t at all aware of.

In the statement released following yesterday’s meeting, Fed policymakers claimed that the rate cut was needed to “help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets.”

At first glance, it smacks a bit of the indecipherable “Fedspeak” that former chairman Greenspan perfected and used to such great advantage during his tenure as the head of the nation’s central bank. Indeed, the statement doesn’t even seem to make sense.

Sharks and Shysters and Crooks, Oh My

You see, a high percentage of the subprime mortgages that touched off the growing global credit crunch were either fraudulent, or chimerical. Sometimes crooks and shysters just lied about their income to buy houses, assuming the market would bail them out. At other times, financially simple souls  – the proverbial supermarket cashier, or shoe-store clerk – genuinely thought they would be able to afford a $700,000 California house on an $11 per hour wage.

Neither of these two categories will be helped by the reduction in interest rates. In fact, even if those rates dropped to zero, chances are that neither class of borrower could afford the principal repayments or the property taxes on the houses they’d purchased. [Well, I suppose it would be possible if lenders could make zero-amortisation, zero-interest-rate, and 100-year mortgages – and then report them on their books at 100% of their value – since no payments would be missed until 2107!].

The subprime-mortgage mess has caused the money markets to seize up like a Bentley with a leaky crankcase, and that’s no surprise. With modern financial techniques such as securitization and asset-backed commercial paper, nobody had the faintest idea where all this toxic junk ended up, so it’s not surprising that banks wouldn’t lend to each other. The solution, which we’ve seen, is for central banks to lend money “into” the market to make it liquid again. As was true of the prior examples, lower interest rates have no benefit here, either.

However, as I hinted at a little earlier, it is also possible that Bernanke & Co. at the Fed have sighted some nasty storm clouds forming directly in the path of the U.S. economy. Employment unexpectedly dropped by 4,000 last month and yesterday we heard that the NAHB Housing Market Index had dropped to a record low. If there’s a real storm brewing, the Fed was right to slash rates so aggressively. On the other hand, since real economic trouble will bring lower corporate profits, the stock market was mad to zoom upwards.

Playing the Rate Cut

But here’s the good news: You can capitalize on either of these possible scenarios. Take part of the money you had earmarked for investing, and follow the strategy I detailed yesterday, buying shares of the IShares Comex Gold Trust (IAU) exchange-traded fund (ETF). The increased inflation – which the rate cut is very likely to bring – together with a weak dollar and higher commodity prices, will be reflected in a higher gold price. If the U.S.S economy is in reasonable shape, it will take a year or so for the Fed to figure out that inflation is a real problem, and zap rates higher; meanwhile gold prices will zoom.

If, on the other hand, the U.S. economy is in real trouble, the stock market will eventually reflect it as corporate profits fall. To protect yourself against that eventuality, you should buy some put options. I would suggest the long-term Standard & Poor’s put options quoted on the Chicago Board Options Exchange (CBOE: SPX) as a suitable choice.

Buy the longest-dated options possible (currently December 2009) because that gives this scenario time to play out. Also, buy puts that are well out of the money, with strike prices at 1000-1200, compared with the S&P 500 Index’s current level of 1518. Why? Because they’re cheap, that’s why. You’re not going to invest a huge chunk of your money in options – that’s a sucker’s bet. However, if Ben Bernanke really knows something he isn’t telling us, it’s likely the market will fall quite a long way. And if the options have a long time span until they expire, out-of-the-money puts have plenty of time to move into the money, should the market drop – meaning they will be worth many times what you paid for them.

As well as making you money directly – via this little strategy I’ve outlined here – long-dated put options provide some insurance for the rest of your portfolio, in case of a market collapse.

Finally, if you want to avoid the challenges and risks of trying to guess just what the Fed’s up to, I suggest you invest your money in a market as far away from the U.S. economy as possible. And, as I said yesterday, that would be in Japan.

Invest in the streetTracks SmallCap Japan ETF (JSC), which consists mostly of domestically oriented Japanese companies, safely insulated from the ongoing U.S. financial shenanigans.

[To see our news report on yesterday’s Fed action, click here. To read an analysis of the rate-cut decision by Contributing Editor Keith Fitz-Gerald, click here.]

News and Related Story Links:

• Money Morning News: Bellwether Blue Chip Stocks Record Best Week Since April.

• Dom Pérignon.

• Louis Roederer.
• Money Morning: How to Play Today’s FOMC Meeting.

While central banks in the United States and Europe did their best to infuse their respective economies with liquidity, central banks in China and Japan were doing just the opposite. The People’s bank of China last week sold $20 billion worth of three year treasury bills hoping to siphon off excess funds and cool off its economy.

Meanwhile the credit crunch that has taken hold in the United States and Europe introduced the largest injection of funds since early August into the banking system. The Federal Reserve injected $31.25 billion of liquidity, the largest single-day amount since August 10, while the European Central Bank (ECB) lent banks an extra $58 billion and The Fed’s decision to add liquidity was prompted by the need to keep the primary funds rate at its target level of 5.25%.

China, by contrast, raised the level of funds banks are required to set aside for the seventh time this year. Japan, which, after a decade of inflation has the lowest interest rates in the world, is also moved its rates higher, from 0.43% to the target 0.5%.

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For U.S. Federal Reserve Chairman Ben S. Bernanke and policymakers at the central bank’s Federal Open Market Committee, the verdict is in.

A mediocre – or even week – jobs report for the month of August might have been enough to secure an interest-rate cut at the FOMC’s Sept. 18 meeting. But investors who were wishing for just such a scenario got more than they bargained for with the release of an abysmal employment report on Friday. The cries of “Recession!” could be heard up and down Wall Street. And now Bernanke & Co. may be forced to provide relief in the form of a rate cut. The only question now is how big that rate reduction will be.[To read the Money Morning news analysis on Friday's jobs report - and the stock-market opportunities it may create - click here].

The economy shed 4,000 jobs last month marking the first decline in payrolls in four years. The number of jobs added in June and July was revised downward.  June’s increase was reduced by 57,000, and July’s by 24,000. Factory payrolls took the biggest hit in August, dumping 46,000, the most since 2003. After losing 14,000 jobs in July, the building industry cut another 22,000.  Despite the losses, however, unemployment remained unchanged at 4.6%.

Investors reacted violently.

The Dow Jones Industrial Average plunged 249.97 points, or 1.87%, to close at 13,113.38. The Standard & Poor’s 500 dropped 25 points, or 1.69%, to close at 1,453.55. The tech-laden Nasdaq composite index dropped 48.62 points, or 1.86%, to close at 2,567.70.

The jobs report had been highly anticipated because the payroll report is considered a very good early indicator of an oncoming economic contraction.  There had been a great deal of uncertainty in the weeks leading up to the report’s release, and rampant speculation about whether or not the Federal Reserve would cut the main interest rate. Earlier this week, it appeared to be a win-win situation. If the jobs report were good, it would have meant that the economy was coping well with credit hardships and a weak housing market.  A weak jobs report would have forced the Fed to act, but a report this negative caught just about everyone off guard.

So, now, the floor is open to discussion concerning just what kind of shape the economy is in, and what the Fed should do about it.

According to Joel Naroff, president and chief economist of Naroff Economics: “The job situation has turned dramatically, removing any impediment to a Fed ease.”

In fact, it’s no longer a question of the Fed having to prove it’s not playing to Wall Street speculators or private investors who tried to make a big score on a house.

“This report is weak enough that the Fed has to show it is getting out in front of the weakening economy and not lagging behind, as it had been,” Naroff said.

Economists at Goldman Sachs Group Inc., (GS) adjusted their prediction for the Fed’s next move, raising their rate-cut forecast to half a percentage point.
In an e-mailed statement, Representative Barney Frank (D), who heads a congressional committee that oversees the U.S. Federal Reserve, made a point to say, “A strong response is required – specifically, a meaningful interest-rate cut.”

Still, there are others who disagree, and feel as though the August jobs report was something of an anomaly. As U.S. Treasury Secretary Henry Paulson pointed out in an interview with Bloomberg Television, “Data does not always move in a straight line, so occasionally you will find some surprises. The economy will continue to grow in the second half of the year.”

His perspective seems to be in the minority, however.

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When Fed Chairman Ben S. Bernanke addresses the Kansas City Fed’s annual economic symposium in Jackson Hole, Wyoming, today (Friday), he’ll have to acknowledge that the risks to U.S. economic growth have increased – especially with the disruption to the credit markets and the tightening of credit in many areas. But Bernanke will also likely be emphasizing that inflation – while showing many encouraging signs of being weakened – hasn’t been totally conquered, yet, either.

The Fed chairman finds himself in a very tough spot. If you’ve been reading the business pages of your favorite newspaper, visiting the financial sites online, or even watching the cable TV finance programs, you know by now that many of the most-vocal top executives from interest-sensitive sectors are clamoring for the U.S. Federal Reserve to cut interest rates.

But as I’ve been saying for months now, it’s very important for the central bank to move cautiously, and to maintain an unemotional, objective view that corresponds to actual developments in the real economy. Bernanke and the Fed absolutely cannot give in.

And many agree with me.

Indeed, top executives from soundly run banking institutions like Wilmington Trust (WT) are confident about the strength of the economic activity that they are seeing in their areas right now. They also do not see the need for lower rates right now. After all, folks such as Wilmington Trust didn’t indulge in same excesses as some of their less cautious counterparts.

What we don’t need is a repeat of 1998, when the Fed essentially fueled both the dot-com bubble and an unsustainable rate of growth for the U.S. economy, when it slashed interest rates to stave off the effects of the Long-Term Capital Management hedge fund implosion, the Asian Contagion and the Russian market collapse.

Nor do we need a repeat of the speculative housing bubble that stemmed from the record series of interest-rate reductions that the Fed engineered from 2002-2003. During that sad episode, speculators were able to capitalize on the availability of cheap, easy and innovative credit to buy houses they could then “flip” for a quick profit. That might happen several times with the same house before it was ultimately purchased for occupancy. The upshot: Many consumers ended up buying houses that were out of their price range and that they could not afford, because that’s all that was available in the marketplace.

In essence, speculators were “front-running” the ultimate buyers who wanted to actually own and occupy the home. But unlike other areas of finance, this type of “front-running” was perfectly legal. It was made possible by such innovative developments as interest-only loans, or loans with negative amortization – in short, many off the types of loans that are creating the current credit problems out in the marketplace. What’s more, in many cases these loans were used to buy houses where the speculators’ entire profit case was the so-called “Greater Fool” Theory: In short, the speculators worried very little about the “innate” value of the house they were buying, so long as they could be reasonably sure it would sell to someone else at an even-higher price.

Now, the “Greatest Fools” – the most-recent buyers – are stuck, if they are forced to sell immediately. This baseless-buying drove prices of homes in the speculative areas way above fundamentals, creating notable bubbles, which are now being quickly deflated. Such mis-pricing in these speculative areas is very negative to the economy, since it represents a real mis-allocation of capital – and since it also has inflationary implications.

Note that where home buying was based on traditional financing, prices have not declined significantly. In other words, where homes were financed with so-called “conforming” mortgages – or mortgages that didn’t exceed the $417,000 maximum that government-sponsored entities like Fannie Mae (FNM) could guarantee – prices have not declined significantly, recently. That’s because the irrational speculation in those geographic regions is very small, since so few homes were financed with the “jumbo” loans that carried the adjustable rates and low – or no – down payments. There just wasn’t a lot to “irrationally speculate” about.

But in his address to the Kansas City Fed folks in Jackson today, Bernanke will be speaking right after having the benefit of seeing the Fed’s preferred inflation gauge, the core PCE deflator, that comes out at 8:30 a.m. This will likely show a continuation of the gradual weakening of this inflation measure, which will probably come out at 1.8% or 1.7% for the last 12 months, still too close to the upper end of the Fed’s “comfort range” of 1% to 2%. Bernanke should also note that the central bank is very closely monitoring any market dislocations, and that the Fed stands ready to keep ensuring liquidity – just as the Fed has successfully accomplished in the credit markets recently, in joint coordination with the European Central Bank.

It’s very important that Bernanke buy some time in order to get additional confirmation in the economic data that growth and more importantly, inflationary pressures, are indeed abating and that inflationary expectations are very low before he reduces rates. This might not happen until after the next Fed policymakers meeting, on Sept. 18.

You see, as it looks right now, the economic indicators just don’t show the kind of slowdown that would warrant an interest-rate cut. Here’s why: Economic growth is still strong.

Keep in mind that making monetary policy is part art/part science, and because monetary policy works with lags, the Fed will no doubt reduce rates before seeing inflation at low or negative levels and before sending the economy into recession, but we don’t seem to be there yet.

The bottom line is this – and it’s one that’s most important to note: There’s a large speculative bubble blatantly evident in high-dollar (non-conforming mortgage) homes that is being rapidly deflated, while the rest of the U.S. economy is still growing in a healthy manner. Inflation is still abating, albeit gradually, and isn’t beaten, yet.

Since we don’t want a repeat of 1998, the Fed needs to refrain from over-reacting to the speculators’ despair and just continue its current strategy of making sure there is adequate liquidity in the credit markets – while the markets gradually sort out their speculative-credit losses and work their way back to their normal function. By staying strong, and showing resolve here, the Bernanke Fed will cement strong, non-inflationary growth in the U.S. economy for years to come.

Related News and Story Links:

• Money Morning Investment Analysis: The Fed Has Learned Balance as it Aids Market Recovery.
• Money Morning Market Commentary: Manage Your Risk and Boost Your Profits, Even in a Volatile Market.
• Money Morning News Report: Low Consumer Confidence Unlikely to Motivate Fed; Stocks Plunge.
• Wikipedia: Long-Term Capital Management.

The level of outstanding commercial paper underwent its biggest weekly drop in at least seven years in the period that ended Wednesday, further evidence of how the credit crunch has shaken the financial markets.

Commercial paper is a highly flexible, unsecured, short-term loan obligation with a maturity term that typically ranges between two and 270 days. Often issued directly by a bank or company without using a broker, commercial paper enables a firm to finance its day-to-day operations and capital needs without having to worry about the natural ebb-and-flow of outstanding revenue, loans, or cash flow. But companies can fall into a liquidity crisis when a crisis of confidence makes it impossible for them to issue this kind of very short-term debt – and can even force a company to seek shelter in the bankruptcy courts.

Indeed, Tony Crescenzi, chief bond strategist for Miller Tabak & Co., described it for MarketWatch as a market “that has shown virtually no tolerance for bad credit or risky entities for more than 30 years.”

In a market note to clients, Crescenzi said the commercial paper market could shrink by as much as $300 billion – equal to the amount of commercial paper backed by mortgage loans. If that happens, it “absolutely will have a negative effect on the economy, arguably in need of offset by new liquidity from the Federal Reserve.”

But Alan Mulally, CEO of Ford Motor Co. (NYSE: F), told the Dow Jones news service this week that he doesn’t think that will be enough. He’s essentially now backing a call by Bob Nardelli – the newly appointed head of Chrysler Corp. – to stop worrying about inflation and start worrying about a recession. The bottom line: Cut interest rates.

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Mulally said the lackluster economy and the badly soured credit markets had turned into a “big headwind” that’s now bucking his plan to turn around a carmaker that lost nearly $13 billion last year. Asked whether he agreed with Nardelli’s call for a short-term interest-rate cut, Ford’s Mulally said this quickly widening confidence chasm was turning this from a watch for inflation into a wave of worry about a major economic downturn.

"It is a really important job to manage inflation and economic growth [but] focusing on economic growth appears to be a really important priority now," Mulally said. Everyone is right now worried about the “macro economy…especially right now in the U.S. [market] with subprime [worries] and [higher] fuel prices,” he said. “Our business is really dependent on consumer confidence.”

The Ford chief’s comments are just the latest evidence that Corporate America and much of mainstream America is starting to think that the Federal Reserve is focusing on the wrong battlefront, and that it’s allowing the housing and credit crises to spread, almost unchecked. The commercial paper market is voting the same way, it appears.

Outstanding commercial paper dropped $90.2 billion this past week after plummeting $91.1 billion the week previous, according to the U.S Federal Reserve. Commercial paper has fallen a total $181.3 billion in the past two weeks, and $144.4 billion so far this month. In the week that ended Wednesday, asset-backed commercial paper fell by $77.1 billion, following a $48.4 billion drop.

According to debt-rating agency, Fitch Ratings, a total of $891 billion is at risk because of credit agreements on asset-backed commercial paper programs. The recent fall has been driven by a 6.8% decline in asset-backed commercial paper, which represents half the commercial paper market.  Investors have abandoned commercial paper, and are seeking safer positions in the confines of government debt, which has pushed the Treasury bill yields down to near-historic lows.

The three-month T-bill yield has fallen well below 4.0%, and during an intra-week situation, fell below the 3.0% mark. On Monday, the yield on the three-month T-bill fell 66 basis points to 3.09%, after dropping 125 basis points earlier in the day – a greater plunge than during the October 1987 stock market crash. The yield on the one-month Treasury bill fell 62 basis points to 2.33%, after being down 175 basis points.

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All things considered, U.S. central bank chief Ben S. Bernanke and the Federal Reserve have so far demonstrated a tremendous amount of restraint amid the credit crunch.

Market volatility, tightening credit conditions, and the collapse of the subprime-mortgage-stuffed Bear Stearns Cos. (NYSE: BSC) hedge funds – as well as several mortgage lenders operating at the highest end of the risk spectrum – have left many investors nervous. Still, the Fed’s hand remains steady.

On Aug. 7, when Fed policymakers last met, the central bank stood at the precipice of the most disturbing market trouble this year. At the time, it was obvious that a market downturn was looming, and that the subprime mortgage crisis was puffing smoke like a long-dormant volcano that was ready to blow. Curious observers began to speculate that the Fed would take action, cut rates, and preempt what could only become an uglier situation.

But the Fed did nothing.

It acknowledged that the U.S. stock market was volatile, that the U.S. housing market was in peril, and that lending conditions were less than ideal. But it was just as clear that inflation remained the central bank’s main concern. When the two Bear Stearns funds collapsed, and one of the largest banks in Europe –BNP Paribas SA (EPA: BNP) – was forced to freeze a couple of money-market funds that were also loaded with asset-backed commercial paper containing subprime exposure, it was the European Central Bank that took action first.

The ECB was forced to inject a record $130.6 billion in added temporary liquidity into the banking system. The Fed injected another $24 billion dollars.  By the end of the week the ECB had issued $214.2 billion, while the Fed had supplied $59 billion to its banks. Last week, Fed Chairman Bernanke announced the reduction of the bank’s discount rate, but held its benchmark Federal Funds rate steady at 5.25%. The Fed Funds target rate is what Fed system banks charge one another for overnight loans.

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With their coordinated approach, the ECB and the Fed seemed to add enough liquidity to keep their respective banking systems operating at a reasonably normal level – without having to cut their target rates. In the Fed’s case, that action would run the risk of placing too much liquidity into the financial system. That, in turn, could over-stimulate the U.S. economy, and its banking system – and which would also let the subprime speculators off the hook, since many would be able to refinance, and avoid bankruptcy.

If you think back to 1998, the crisis of the day was the implosion of the Long-Term Capital Management hedge fund. After Russia defaulted on its domestic GKOs, an overleveraged LTCM, and a number of other speculators were forced to purge large portions of their assets. The result was a mad dash to the exits. 

The Fed made its move, cutting interest rates twice successively and fixing the problem in that one swoop. Sure enough, however, the law of unintended consequences came into play. The U.S. economy grew at an 8% clip in the last quarter of 2000, driving runaway investments in overvalued tech stocks, and also fueling a corporate and consumer credit binge that led to the 2002-2003 downturn.

The Fed may have learned its lesson. Now it seems reluctant to overreact and potentially create another bubble – and won’t easily opt to “bail out” reckless speculators, blind-to-risk borrowers, and super-aggressive lenders. Instead, the Fed has taken adequate measures to ensure market liquidity, and it has attempted to redress the negative impacts of a global credit crunch.

In short, it is not the central bank’s job to rescue banks or bail out investors who made ill-advised choices. Instead, it’s chief mandate is to, first, battle inflation wherever and whenever it appears; and, second, to remain vigilant against major drop-offs in economic growth.

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Central banks continued funneling cash into the world’s wounded financial systems Monday, the latest in a series of liquidity infusions that began last week. The European Central Bank offered another $65 billion in emergency funds, while the Bank of Japan injected $5.1 billion. The Federal Reserve again came in on the low end of the scale, injecting $2 billion.

As a result, Europe’s Dow Jones Stoxx 600 index had made its biggest climb in more than a year, 2.3%, after dropping 2.6% last week. The FTSE 100 index closed up 180.7 points, or 3%, marking its biggest gain since 2003.  

U.S. stocks failed to make such noteworthy comebacks. The day started off with an optimistic tenor as market indexes spent most of the day in the black. Fears concerning the ongoing credit crunch were assuaged as central banks continued to offer loans, along with the release of an impressive sales report.

But the Dow Jones Industrial Average and Standard & Poor’s 500 Index both slightly down, at 0.2% and 0.5%, respectively. At their highest point in the day the Dow was up 0.7%, and the S&P 0.8%. Unfortunately they could not sustain a comeback, and collapsed at the closing bell.

Some came out ahead however. Blackstone Group (NYSE: BX) picked up 1.7% after reporting it had tripled its quarterly profit and revenue.  Alcoa (NYSE: AA) climbed 2.45%, and Hewlett Packard (NYSE: HPQ) jumped 2.58%. 

Whenever I’m faced with a market like this one – rocky and volatile, with hidden wildcards just waiting to trip us up – I can’t help but think about my late grandmother, successful amateur investor Virginia Gruner, and the warning she would issue in just these situations: “Hold onto your bippies!”

As I sit here and stare at my trading screens this afternoon (Monday) – watching as central banks around the world inject billions into the global economy in an effort to blunt the effects of the spiraling credit crisis – I can just hear my grandmother issue her ever-so-familiar warning.

The Greatest Investor I’ve Ever Known

You see, my grandmother was a super-successful amateur investor.  She’d spent most of her adult life managing her household, the wife of a highly successful insurance-industry executive (my grandfather). When her husband died, my grandmother found that her family’s own finances were in disarray. So with characteristic commitment, and with a resolve I always admired, she set out to become a successful investor. She became one of the smartest individual investors most of us will ever see – and, actually, one of the best investors of any kind I have ever known.

My grandmother then set out to pass that “gift” along – to me. Starting when I was a teenager, she made sure that I always had the entire Value Line investment research series, and annual subscriptions to such leading publications as Business Week and Forbes. She wasn’t forcing this on me, mind you, but rather was sharing it with me – and in a way that made me want to learn all that I could, and be as successful at this wonderfully engaging pursuit as my grandmother.

Yesterday’s late-afternoon trading patterns suggest that her bit of wisdom may somehow be fitting to keep in mind over the next few days. I’m now hearing from traders based both here in the United States and around Europe that the $275 billion injected into the world economies by the global central banks may not be enough.

And, yet, Asia’s traders seem placated.
 
So, what gives?

I honestly don’t know. But here’s what my experience tells me should be happening – as well as what’s actually happening.

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The Global Realities

Somehow, the Euros and Americans don’t trust the system. They think that Monday’s rally is nothing more than a continuation of the short covering and limited bottom fishing that began Friday on the heels of nearly $275 billion in central bank liquidity injections

They’ve got a bad case of: “I’ll believe it when I see it.” And investors seemingly want the ECB and Fed to drop rates as a sign of good faith that things are truly behind us. Yesterday, in fact, I saw no fewer than 20 different news stories, research reports, and market essays from various people suggesting that a “Fed rate cut is in the bag” – which makes me suspect all the more that it isn’t.

Asian traders, on the other hand, seem to think that the massive amounts of money shot into the system was enough to fix the problem.

It’s the way that the Asian markets are trading that leads me to draw this conclusion – that, of course, plus the 20-plus years I’ve spent in and around the Asian markets.

The Japanese and Chinese in particular have a different cultural framework than we rely on here in the West. As a result, the Japanese have a sort of implicit trust in the government as a benevolent entity while the Chinese view it as a strict leader to be obeyed…maneuvered, but obeyed nonetheless. There are, of course, finer points to each but those are more academic than anything else.

In more practical terms, based on how the two camps (the West vs. Asia) appear to be divided in their trading philosophy right now, what we as individual investors are left with is a dichotomy: Roughly half the world’s financial system wants more “liquidity,” while the other half seems content with what it’s got.

Really Time to Go Global

So, who’s right and what does it mean for us?

That remains to be seen. I’m personally of the opinion that we have a long way to go before the extent of the damage is truly recognized. There will undoubtedly be some big names on the chopping block in the weeks to come as more light is shed on this messy credit situation. Some of these revelations will have been anticipated. But others will be huge surprises, and could well roil the markets.

Either way, this suggests to me that individual investors have yet another reason to focus at least part of their financial strategies on global investing (Wharton Professor Jeremy Siegel recently said that an international allotment of under 40% was a “disservice,” as well as a recipe for substantial underperformance).

That said, it’s clearly not enough any more to diversify by country because most of the countries, as so many people found out last week, are inextricably linked at the central banking level.

Therefore, it is vitally important to take a different approach that both lessens your risk and heightens your potential returns. Part of that approach includes lining up your money with the virtually unstoppable trends of our time. The other part suggests “an offensive defense” may be more appropriate now more than ever.

Last week’s financial shenanigans have clearly changed the rules of the game – yet again.

As I reason this all through, I can’t help but consider what my grandmother would say about this situation. The best revenge, of course, is to take advantage of all possible profit opportunities. But we all know that these next few weeks could be highly volatile, which either connotes danger or opportunity – depending upon your viewpoint.

So brace yourself for still more volatility (“hold onto your bippies!”). Then capitalize on whatever opportunities the financial markets throw at you. Look especially closely at global investment opportunities, but don’t be afraid to be opportunistic domestically, either. Be bold, but not reckless.

And have at it!

Good Investing to us all.

 Keith Fitz-Gerald

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