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Credit Cycle Bottoms


History is filled with denial transactions issued at bigger and bigger discounts through deteriorating credit cycles.

The following is the latest from Minyan Peter, author of such popular recent articles as Bank Debt Downgrades: Surf's Up and Asset Deflation Driving Move Toward Recession.

Over the past three months, we have seen the full swing of the bank capital pendulum as we have moved from stock buybacks to stock issuance. No longer is there surplus capital to return to shareholders, but instead there is a significant capital deficit and the need to raise additional equity.

Many will look at yesterday's announcement by Citigroup (C) as the "capitulation" trade, signaling the bottom of the credit cycle. But like Bank of America's (BAC) investment in Countrywide (CFC) earlier this fall, I believe that yesterday's transaction will join a long list of capital financings in history that occurred, not at the bottom of the credit cycle, but during the "denial" phase.

The credit cycle denial phase is reflected in the willingness of a bank to issue highly dilutive equity and investors' willingness to buy it at a significant discount. In contrast, however, at the bottom of credit cycles the willingness of a bank to issue extremely dilutive equity is met with investors' unwillingness to buy bank equity at any price.

History is filled with denial transactions issued at bigger and bigger discounts through deteriorating credit cycles. And one need only go back through the early part of the credit cycle of 1987-1991 to see capital raised by ultimately failed banks.

That is not to say the denial phase is all bad. I expect that over the next month or two as transactions, such as those contemplated for Freddie Mac (FRE) and Fannie Mae (FNM) are oversubscribed (and they will be), temporary confidence will be restored and most bank stocks will rally.

But should the economy continue to deteriorate as I expect, the banking system will once again require further capital and the "denial" that once joined bank issuers and investors together will be transformed to fear. And with that capital will be raised not through equity issuance, but through sales of non-credit assets at fire sale prices. Those able to throw good assets overboard will survive. Many will not be so lucky and will end up in the arms of the regulators.

As much as we may be critical of the terms struck by Citigroup, the deal got done. Remember, credit cycle bottoms are defined more by what couldn't get done than what could.
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