By: Elliot Turner
The market was gapping down even before this morning’s disappointing Initial Jobless Claims. Financials, led by Citigroup’s failed offering, continued to weigh on the market. Citi lost another 7.5% and sector leaders, JP Morgan and Goldman Sachs, both closed below their recent support levels. Despite today’s selloff, the S&P remains comfortably within its recent range, although that may change in the near future if the persistent weakness in financial stocks continues. In the coming days, we will closely watch the action in these stocks as an indication of broader market health. Price action tells us that investors once again have concerns about the health of financial stocks and fear the prospect of a post-TARP Citigroup.
The government guarantee against failure helped boost the price of Citi’s shares by removing a degree of risk for shareholders–everyone knew that bankruptcy was not an option–and providing the “heads I win, tails I don’t lose” moral hazard incentive for the bank to place bets with equally obscene levels of risk and reward. As a member of the Too Big to Fail Club, Citi could engage in risky endeavors knowing the U.S. government would backstop any losses. Knowing this, speculative demand for shares led to prices disproportionate to the fundamentals of the company’s balance sheet. Bailout speculators were simply betting on the government guarantee resulting in a vivacious and healthy bank down the road, with minimal downside risk, when in reality the company continues to face considerable headwinds. Felix Salmon offers this glimpse into the reality of secondary offerings for the financial sector :

The Citigroup secondary offering yesterday, which went much worse than planned, is a prime example of the difference between primary and secondary markets…

The first type, which is based on perceived fundamentals, is the price that investors are willing to pay to own a stake in the company over the long term. The second type, which is based on markets, is much more speculative, and is fundamentally a bet on what other people will be willing to pay for the stock in the short term.

If you have a type-1 stock, it’s pretty easy to sell new stock at or near the secondary-market price. If you have a type-2 stock, however, it can be very hard. And a lot of people looking at the rise in bank stocks since March were wondering…how much of it was momentum trading and speculation, and how much of it was based on fundamentals.

Certainly a large part of it was speculative — a large part always is. Speculators are short-term liquidity providers, but you need long-term fundamental investors to represent a significant share of the market in order to be sure that the share price won’t collapse overnight…

Similarly, today, shares in AIG can bob around in significantly positive territory for as long as they like, but there’s no way that the company could ever get a secondary stock offering away.


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