Over the weekend, Barron's published an article singing the praises of adjustable-rate preferreds. As is typical, Barron's trucked out Bill Gross to lend legitimacy to its argument. The article quotes Mr. Gross's opinion that recent government rescue measures for banks makes both bonds and preferreds issued by these institutions safer. He may be right about financial sector debt, at least out to June of 2012 (the end of the TLGP FDIC program - I wouldn't trust any financial bonds other than those issued by the biggest deposit taking banks which did not need extra help from the government beyond that point), but I think preferreds, especially traditional non-cumulative preferreds are more at risk for dividend suspensions. Why? because the cash saved can help a bank's capital ratios without further government assistance. We have already seen the wiping out of GSE preferred dividends and the Fed has asked several regional banks to suspend dividend payments. Citing the fact that a certain large bank has essentially wiped out its common dividend, but has left preferred dividends untouched as a point of comfort is foolish. By doing so this bank has made the suspension of preferred dividends the next line of defense. The 200 to 300 basis point spread between this bank's non-cumulative preferreds and its cumulative trust preferreds says that the market is concerned. But dividend suspensions are not the crux of my critique of the Barron's article.
My criticism centers on the relative value of adjustable-rate preferreds. The article states that adjustable-rate preferred dividends can only go up from this point. This is generally true. However, this does not necessarily mean that they will experience price appreciation. Why? Preferreds are credit products which trade at spreads versus treasuries, but which treasuries?
Preferreds are long-term or, in the case of non-cumulative preferreds. perpetual securities. This means that they trade versus long-dated treasuries. However, their coupons are set versus short-term benchmarks (usually three-month LIBOR). This means that one doesn't necessarily need short-term yields to rise in absolute terms, but rather in relation to long-term yields. LIBOR-based preferreds perform best perform best when the yield curve is flat or inverted. We have evidence of this with MERprG. MERprG reached a premium of $26.55 on 2/2/07. The yield curve at that time was slightly inverted. I don't think we will see economic conditions necessary for a curve for a long time.
The Fed will do what it can to keep short-term rates low for the time being, but even when the Fed feels the need to raise short-term rates (during an eventual expansion) inflation caused by not only growth, but the massive amounts of money being printed (not to mention the huge quantities of debt being issued) promises to push long-term rates higher as well. This means that even if credit spreads between preferreds of any kind and treasuries tighten, prices may not rise much, if at all, because the coupon on the floaters will lag long-term rates, I.E. the yields at which new preferreds would be issued. This would keep the floaters priced at significant discounts.
Floaters may not trade any better than existing high-coupon fixed-rate preferreds. Most floating-rate preferreds spread their coupons anywhere from 35 basis points to 100 basis points over three-month LIBOR. Thus, even when considering a preferred which sets its dividend 100 basis points over three-month LIBOR, we would need to see three-month LIBOR at 7.00% or more for a 100 basis point floater to equal the coupon of existing high-coupon preferreds. The last time we had three-month even at 6.50% was after Alan Greenspan jacked the Fed Funds rate to over 6.00% quash the tech bubble. One also must consider that any price gains one experiences on floater may be similar to those on high-coupon preferreds and, even if they are greater, one has to consider the income deficiency of the floater versus the fixed-rate. Total return still probably favors the high-coupon fixed-rate preferred.
Lastly the article describes floating rate preferreds as a hedge versus inflation. This only exposes the author as being unknowledgeable. Long-term rates reflect inflation expectations, not short-term rates. If higher inflation is expected, these preferreds should trade in ways which reflect a steeper yield curve. TIPs five to ten years out are cheap. If one wants an inflation play, buy TIPs. Buying floating-rate preferreds to play inflation is like buying a minivan to go racing at Indy.
Have a Happy New Year!
Monday, December 29, 2008
Friday, December 26, 2008
Wouldn't you like to be a bank too?
GMAC and its bondholders received a gift from the Fed on Christmas Eve. In spite of being undercapitalized and being jointly owned between a private equity firm (Cerberus) and a failing automaker (GM), GMAC was granted bank holding company status with the Fed invoking emergency powers to complete the deal. GMAC will now have access to the full range of Fed liquidity programs and, in theory, the ability to issue FDIC-guaranteed TLGP corporate bonds. This takes GMAC creditors out of the fire, past the frying pan and back onto the cool kitchen counter of the fixed income world.
For GMAC to become a bank holding company, GM will transfer its ownership in GMAC to a trust which will sell its stake in GMAC over the next three years. Cerberus must reduce its stake in GMAC from 51% to no more than 14.9% in voting shares and 33% overall. According to the Wall Street Journal, although GMAC and Cerberus are divesting their investments in GMAC, they are required to add a combined $750 million to GMAC's balance sheet and that number could grow to $2 billion.
What does this mean for GM bondholders? It means that GM has a chance at survival as it will have a finance company to fund purchases of GM vehicles. However, I am still of the opinion that GM creditors will receive less than par for their bonds.
CIT was also granted bank holding company status. This means that it could issue FDIC-guaranteed bonds. Uninsured CIT bonds maturing within the TLGP period (out to 6/30/12) are probably worth holding and could represent buying opportunities for more sophisticated investors. Conservative and moderate risk investors holding longer-term CIT bonds may want to sell into any strength.
I have been of the opinion that non-cumulative preferred stock present significant dividend suspension risk due to their being on par with the government's level of preferred investment and the possibility that the government could order those dividends suspended if it deems it necessary. According to an article on CFO.com, the Fed has ordered three small banks Michigan Heritage Bank, Birthright Inc. and Cherokee Bancshares to suspend dividends so that the banks can maintain their "financial soundness".
This is something I and my more experienced colleagues have feared since the government's increased involvement with the running of U.S. banks. The article states that the banks in question cannot declare or pay any dividends with out first obtaining written permission from the Fed, the director of the Division of Banking Supervision and Regulation of the board of governors, and Office of Financial and Insurance Regulation. All requests for prior approval must be received by the Reserve Bank and OFIR at least 30 days prior to the proposed dividend declaration date and must contain, at a minimum, current and projected information on earnings, capital, asset quality, and loan loss reserve needs of the Bank.
If the Fed can do this to small banks it can to it to any bank. No mention was made of interest payments. This is because, short of seizure, the government cannot restrict banks from paying their debts. In fact, the suspending of dividends is ensure that banks can meet their financial obligations. I will say it again, investors considering investing in preferreds should consider trust preferreds as they actually pay interest and, if the dividend is voluntarily suspended, it is cumulative and must be paid to investors unless the bank fails or falls into some kind of receivership.
Here's to a better year in 2009
For GMAC to become a bank holding company, GM will transfer its ownership in GMAC to a trust which will sell its stake in GMAC over the next three years. Cerberus must reduce its stake in GMAC from 51% to no more than 14.9% in voting shares and 33% overall. According to the Wall Street Journal, although GMAC and Cerberus are divesting their investments in GMAC, they are required to add a combined $750 million to GMAC's balance sheet and that number could grow to $2 billion.
What does this mean for GM bondholders? It means that GM has a chance at survival as it will have a finance company to fund purchases of GM vehicles. However, I am still of the opinion that GM creditors will receive less than par for their bonds.
CIT was also granted bank holding company status. This means that it could issue FDIC-guaranteed bonds. Uninsured CIT bonds maturing within the TLGP period (out to 6/30/12) are probably worth holding and could represent buying opportunities for more sophisticated investors. Conservative and moderate risk investors holding longer-term CIT bonds may want to sell into any strength.
I have been of the opinion that non-cumulative preferred stock present significant dividend suspension risk due to their being on par with the government's level of preferred investment and the possibility that the government could order those dividends suspended if it deems it necessary. According to an article on CFO.com, the Fed has ordered three small banks Michigan Heritage Bank, Birthright Inc. and Cherokee Bancshares to suspend dividends so that the banks can maintain their "financial soundness".
This is something I and my more experienced colleagues have feared since the government's increased involvement with the running of U.S. banks. The article states that the banks in question cannot declare or pay any dividends with out first obtaining written permission from the Fed, the director of the Division of Banking Supervision and Regulation of the board of governors, and Office of Financial and Insurance Regulation. All requests for prior approval must be received by the Reserve Bank and OFIR at least 30 days prior to the proposed dividend declaration date and must contain, at a minimum, current and projected information on earnings, capital, asset quality, and loan loss reserve needs of the Bank.
If the Fed can do this to small banks it can to it to any bank. No mention was made of interest payments. This is because, short of seizure, the government cannot restrict banks from paying their debts. In fact, the suspending of dividends is ensure that banks can meet their financial obligations. I will say it again, investors considering investing in preferreds should consider trust preferreds as they actually pay interest and, if the dividend is voluntarily suspended, it is cumulative and must be paid to investors unless the bank fails or falls into some kind of receivership.
Here's to a better year in 2009
Tuesday, December 16, 2008
Go, Go Godzilla
Following the today's FOMC rate decisions, we could forgive a certain big lizard for mistaking the U.S. for Japan. After all, the yields found among our U.S. treasuries look remarkably similar to those found in Japan in the 1990s. Truthfully, yields were lower in 1990s Japan, but you get my drift.
The FOMC's rate decision surprised many Wall Street forecasters. The Street had been divided into two camps, one forecasting a 50 basis point rate cut and another forecasting a 75 basis point rate cut. The Fed did one better by setting the Fed Funds rate to a range of 0.00% to 0.25%. A range you say? This was common decades ago and permits lending within a range depending on conditions. Essentially, the Fed lowered the Fed Funds rate to zero without officially doing so.
The Fed's statement pulled no punches. Mr. Bernanke and Co laid it all on the line. Here is a copy of the FOMC statement:
The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.
Since the Committee’s last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further.
Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.
The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.
The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.
In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco. The Board also established interest rates on required and excess reserve balances of 1/4 percent.
The Fed acknowledged that weak economic conditions will persist for some time and that it will employ all means at its disposal. Since the Fed has fired all of the arrows in its Fed Funds quiver, what ammunition remains? The Fed can continue to purchase GSE bonds and GSE mortgage-backed securities to lower lending rates. It can also purchase long-dated treasuries to lower mortgage benchmarks. I think this ammunition will in fact be fired. This will keep long-term treasury yields artificially low considering the increased amount of government debt issuance and an increase to the money supply. Although long-term treasury yields fell (as expected) on today's FOMC statement, the U.S. dollar fell versus the euro and the yen. Eventually, the increased printing of money will be inflationary (actually the Fed's goal) that, combined with increased debt issuance, should eventually push long-term yields significantly higher, but probably not until 2010.
How much will long-term rates rise? This is he $20 million question. From a fundamental standpoint, a 6.00% or 7.00% (or higher) 10-year treasury note is not out of the realm of possibility. However, our "trading partners" have vested interests in keeping long-term treasury yields low to keep U.S. consumers borrowing and spending (once economic conditions recover).
The government's overall weaponry is not limited to Fed securities purchases. The Treasury and the Fed will keep banks well-capitalized. Expect more issuance of FDIC insured TLGP bonds. It is imperative that banks remain well-capitalized. Large banks will not be permitted to fail. This means that they will not be permitted to default on bond payments, at least not in the near term.
How and why will government not let large banks default on bond payments? The "why" is easy. Default on any bond payments, and one defaults on all bond payments. This makes banks wards of the FDIC and puts the government on the hook for the payment of billions of dollars of TLGP bonds. The government will not permit this to happen, at least not during the TLGP period which extends out until June 30, 2012.
How will the government keep banks solvent. It will keep the discount window and other "temporary" liquidity programs open. This however would add to banks' Tier-2 capital. If a bank's Tier-2 capital rises to over 100% of its Tier-1 capital, that bank is in violation of the Basel II banking agreements and is considered to be an unstable institution. Other banks will cease doing business with the troubled bank.
The government could purchase more preferred stock shares from banks, but this may only be done in extreme circumstances. What the government could do is order a troubled bank to suspend all common and preferred equity (non-cumulative preferred) dividends payments to conserve cash to make bond interest payments. Not paying preferred dividends would save substantial sums of cash and would not put a bank in regulatory jeopardy. As the government's preferreds rank equal to outstanding non-cumulative preferred stock, it is very easy for the government to order a suspension of these dividends and those of common stock. It may be better for the government to forgo its own dividend payments rather than add more capital. One look at the yield differential between cumulative and non-cumulative preferreds of some issuers tells us that the market is also concerned. Investors may want to consider trust preferreds which are senior to the government and non-cumulative preferreds as they are a kind of junior subordinate debt.
Another opportunity maybe non-FDIC bonds issued by large TLGP-participating banks out to June 2012. These banks will be well-capitalized during that time and significant yield pickups can be had.
I want to apologize for not writing much this past week. I did have some computer issues. I will be on vacation for much of the time between December 19th and January 5th.
Happy Holidays to All
The FOMC's rate decision surprised many Wall Street forecasters. The Street had been divided into two camps, one forecasting a 50 basis point rate cut and another forecasting a 75 basis point rate cut. The Fed did one better by setting the Fed Funds rate to a range of 0.00% to 0.25%. A range you say? This was common decades ago and permits lending within a range depending on conditions. Essentially, the Fed lowered the Fed Funds rate to zero without officially doing so.
The Fed's statement pulled no punches. Mr. Bernanke and Co laid it all on the line. Here is a copy of the FOMC statement:
The Federal Open Market Committee decided today to establish a target range for the federal funds rate of 0 to 1/4 percent.
Since the Committee’s last meeting, labor market conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined. Financial markets remain quite strained and credit conditions tight. Overall, the outlook for economic activity has weakened further.
Meanwhile, inflationary pressures have diminished appreciably. In light of the declines in the prices of energy and other commodities and the weaker prospects for economic activity, the Committee expects inflation to moderate further in coming quarters.
The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.
The focus of the Committee’s policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. Cumming; Elizabeth A. Duke; Richard W. Fisher; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Kevin M. Warsh.
In a related action, the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 1/2 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Richmond, Atlanta, Minneapolis, and San Francisco. The Board also established interest rates on required and excess reserve balances of 1/4 percent.
The Fed acknowledged that weak economic conditions will persist for some time and that it will employ all means at its disposal. Since the Fed has fired all of the arrows in its Fed Funds quiver, what ammunition remains? The Fed can continue to purchase GSE bonds and GSE mortgage-backed securities to lower lending rates. It can also purchase long-dated treasuries to lower mortgage benchmarks. I think this ammunition will in fact be fired. This will keep long-term treasury yields artificially low considering the increased amount of government debt issuance and an increase to the money supply. Although long-term treasury yields fell (as expected) on today's FOMC statement, the U.S. dollar fell versus the euro and the yen. Eventually, the increased printing of money will be inflationary (actually the Fed's goal) that, combined with increased debt issuance, should eventually push long-term yields significantly higher, but probably not until 2010.
How much will long-term rates rise? This is he $20 million question. From a fundamental standpoint, a 6.00% or 7.00% (or higher) 10-year treasury note is not out of the realm of possibility. However, our "trading partners" have vested interests in keeping long-term treasury yields low to keep U.S. consumers borrowing and spending (once economic conditions recover).
The government's overall weaponry is not limited to Fed securities purchases. The Treasury and the Fed will keep banks well-capitalized. Expect more issuance of FDIC insured TLGP bonds. It is imperative that banks remain well-capitalized. Large banks will not be permitted to fail. This means that they will not be permitted to default on bond payments, at least not in the near term.
How and why will government not let large banks default on bond payments? The "why" is easy. Default on any bond payments, and one defaults on all bond payments. This makes banks wards of the FDIC and puts the government on the hook for the payment of billions of dollars of TLGP bonds. The government will not permit this to happen, at least not during the TLGP period which extends out until June 30, 2012.
How will the government keep banks solvent. It will keep the discount window and other "temporary" liquidity programs open. This however would add to banks' Tier-2 capital. If a bank's Tier-2 capital rises to over 100% of its Tier-1 capital, that bank is in violation of the Basel II banking agreements and is considered to be an unstable institution. Other banks will cease doing business with the troubled bank.
The government could purchase more preferred stock shares from banks, but this may only be done in extreme circumstances. What the government could do is order a troubled bank to suspend all common and preferred equity (non-cumulative preferred) dividends payments to conserve cash to make bond interest payments. Not paying preferred dividends would save substantial sums of cash and would not put a bank in regulatory jeopardy. As the government's preferreds rank equal to outstanding non-cumulative preferred stock, it is very easy for the government to order a suspension of these dividends and those of common stock. It may be better for the government to forgo its own dividend payments rather than add more capital. One look at the yield differential between cumulative and non-cumulative preferreds of some issuers tells us that the market is also concerned. Investors may want to consider trust preferreds which are senior to the government and non-cumulative preferreds as they are a kind of junior subordinate debt.
Another opportunity maybe non-FDIC bonds issued by large TLGP-participating banks out to June 2012. These banks will be well-capitalized during that time and significant yield pickups can be had.
I want to apologize for not writing much this past week. I did have some computer issues. I will be on vacation for much of the time between December 19th and January 5th.
Happy Holidays to All
Wednesday, December 10, 2008
Our House
By a vote of 237-170, the House of Representatives approved emergency funding for the automakers. Although this is good news for the automakers, they are not out the woods yet. The deal was the result of negotiations between the White House and Congressional Democrats. Congressional Republicans were mostly left out of the mix. Republican Senators appear ready to exact their pound of flesh. Reports from inside the Beltway are that the Senate does not have the 60 votes required to approve the emergency funding for Detroit. Senate Republicans want to see a significant restructuring of the Detroit Three's business model and more power given to the proposed "Car Czar" and less to Congress. This is consistent with my argument that Detroit needs to be flexible enough to build cars the market demands rather than cars that political agendas demand.
Although a deal to provide emergency funding is likely to pass in some form, bankruptcy filings by GM and, possibly, Chrysler, are not out of the question. In fact, emergency funding now does not eliminate the possibility of bankruptcies a month or two down the road. This possibility is one of the major concerns of Senate Republicans. My opinion is that whether or not GM files for bankruptcy protection, it is unlikely that bondholders (and other creditors) will be made whole. It is difficult for analysts to determine recovery values for bonds because of the political involvement. My belief is that all but the most aggressive investors may want to sell their bonds into any strength provided by the emergency funding plan.
Further clouding the picture was GMAC's unsuccessful attempt to become a bank holding company. The FDIC stated that GMAC does not have sufficient capital GMAC was unsuccessful in its efforts to conduct a debt exchange with its institutional investors. This is now pushing GMAC to the brink of bankruptcy. Logic dictates that if GM is to recover, it needs a viable auto financing unit. However, it is become less likely that GMAC will be that unit. There is a chance that GMAC is also kept afloat as part as the emergency government funding, but no mention has been made thus far. I would also sell into strength if I held GMAC bonds, but having ridden them down to these levels, I would wait to see what if any help GMAC receives as part of the auto bailout.
The Fed announced that it is considering issuing its own debt. The problem is that it is unclear if the Fed has the authority to do so. Another problem is that these securities would be similar to T-Bills and could cause problems in that market. The problems would include pushing short-term yields higher (not what the Fed wants right now) and create confusion as to just what guarantee Fed debt will carry.
The CDS market is not all that sanguine as to the credit quality of U.S. treasuries. Bloomberg News reports that CDS for five-year Campbell Soup bonds (51 basis points) is now lower than that for five-year U.S. treasury notes. This is clearly a market technicality as the treasury can print money. This means that, although the dollar may not be worth as much as it is now, investors in U.S. treasuries will get every dollar owed to them. All Campbell's can promise is a tasty chunky soup. Heck with the winter weather moving into the Northeast, maybe I should go long Campbell's.
Investors who may be thinking that we have seen the last of financial sector asset toxicity may be disappointed. AIG announced that it has amassed another $10 billion worth of losses on bets on the performance of various vehicles and collateral with Goldman Sachs. There are no actual securities involved, merely counterparty contracts between the two firms which stipulate that payments will be made from one firm to the other based on the performance of various vehicles, none of which were owned by either firm. This is yet another example of how the credit crisis is far beyond non-performing subprime mortgages. Financial firm balance sheets are littered with all kinds of esoteric contracts and vehicles. This is probably why Hank Paulson has given up on the TARP plan. In many cases there are no actual assets to be purchased only counterparty contracts. What a colossal mess and there is probably more to come.
Although a deal to provide emergency funding is likely to pass in some form, bankruptcy filings by GM and, possibly, Chrysler, are not out of the question. In fact, emergency funding now does not eliminate the possibility of bankruptcies a month or two down the road. This possibility is one of the major concerns of Senate Republicans. My opinion is that whether or not GM files for bankruptcy protection, it is unlikely that bondholders (and other creditors) will be made whole. It is difficult for analysts to determine recovery values for bonds because of the political involvement. My belief is that all but the most aggressive investors may want to sell their bonds into any strength provided by the emergency funding plan.
Further clouding the picture was GMAC's unsuccessful attempt to become a bank holding company. The FDIC stated that GMAC does not have sufficient capital GMAC was unsuccessful in its efforts to conduct a debt exchange with its institutional investors. This is now pushing GMAC to the brink of bankruptcy. Logic dictates that if GM is to recover, it needs a viable auto financing unit. However, it is become less likely that GMAC will be that unit. There is a chance that GMAC is also kept afloat as part as the emergency government funding, but no mention has been made thus far. I would also sell into strength if I held GMAC bonds, but having ridden them down to these levels, I would wait to see what if any help GMAC receives as part of the auto bailout.
The Fed announced that it is considering issuing its own debt. The problem is that it is unclear if the Fed has the authority to do so. Another problem is that these securities would be similar to T-Bills and could cause problems in that market. The problems would include pushing short-term yields higher (not what the Fed wants right now) and create confusion as to just what guarantee Fed debt will carry.
The CDS market is not all that sanguine as to the credit quality of U.S. treasuries. Bloomberg News reports that CDS for five-year Campbell Soup bonds (51 basis points) is now lower than that for five-year U.S. treasury notes. This is clearly a market technicality as the treasury can print money. This means that, although the dollar may not be worth as much as it is now, investors in U.S. treasuries will get every dollar owed to them. All Campbell's can promise is a tasty chunky soup. Heck with the winter weather moving into the Northeast, maybe I should go long Campbell's.
Investors who may be thinking that we have seen the last of financial sector asset toxicity may be disappointed. AIG announced that it has amassed another $10 billion worth of losses on bets on the performance of various vehicles and collateral with Goldman Sachs. There are no actual securities involved, merely counterparty contracts between the two firms which stipulate that payments will be made from one firm to the other based on the performance of various vehicles, none of which were owned by either firm. This is yet another example of how the credit crisis is far beyond non-performing subprime mortgages. Financial firm balance sheets are littered with all kinds of esoteric contracts and vehicles. This is probably why Hank Paulson has given up on the TARP plan. In many cases there are no actual assets to be purchased only counterparty contracts. What a colossal mess and there is probably more to come.
Saturday, December 6, 2008
It's Getting Better All The Time?
Recent comments by some pundits declaring that the recession may have bottomed are unfortunately premature. Most arguing for an impending economic turnaround point to recessions of the recent past which have lasted from 12 to 16 months. Recent data indicating that the recession probably started December 2007 has bolstered this argument. However, I am sorry to say that this is not your father's recession. This promises to be the worst recession of the post World War II era.
The economy is stuck in a negative feedback loop. Weak home sales, scarce credit and financial industry layoffs have causes a slackening of consumer demand. Weaker consumer demand has resulted in job losses in the broader economy which causes more loan and credit card delinquencies which leads to more financial job losses, tighter credit and weaker consumer demand.
Where does this all end? It ends when home prices are permitted to bottom and the sooner the better. If home prices were permitted to bottom sooner, home values may not have fallen as much as they have and how much they are going to fall. Why would letting home prices bottom earlier, rather than attempting the cushion the blow, have resulted in a relatively more modest decline in home prices?
The Fed has the power to make bank borrowing less expensive. It cannot force banks to lower mortgage rates in lock stop (technically it has no power to force banks to lower rates at all) and it has no power to order banks to lower lending standards from their current stringent standards. As credit remains tight it fosters the aforementioned negative feedback loop. As the feedback loop persists (or worsens) and workers lose their jobs, the pool of potential home buyers persists. Demand for homes softens and, quite possibly, many home owners who did not make poor borrowing decisions and who did not purchase too much home begin to go delinquent or default on their mortgages. The result is persistently lower home prices. The recession cannot be reversed until home prices stop falling and job losses are halted.
This brings us to a "chicken and the egg" scenario. Will job losses moderate when home prices stabilize or will home prices stabilize when job losses moderate? The answer is the former. The U.S. economy is consumer driven. Get consumers (home buyers) back in the game and the employment situation will stabilize. Home prices should be permitted to fall to levels which the current pool of qualifying home buyers will enter the market. This had better occur before the pool shrinks further.
Yesterday's Nonfarm Payrolls report indicating a loss of 533,000 jobs (with a significant downward revision to the prior report) may help speed along Detroit Three rescue plans. The Wall Street Journal is reporting that Congress may be close to passing emergency funding to tide the Detroit Three over until January. Although it is possible that the Detroit Three will survive intact until the start of 2009, it is unlikely that they will receive cash to do what they will. Bond holder show=uld beware, but the Detroit Three bonds are not similar situations.
First: Outstanding Chrysler Financial and DaimlerChrysler bonds are obligations of Daimler, not Chrysler. These bonds are not in danger of default. There is one Chrysler 12.25% bond outstanding which is an obligation of Chrysler, but that was a private placement deal, I believe.
2) Ford is not in imminent danger of defaulting in the near future so there is more time to to work out an assistance package.
3) GM needs help NOW!!! GM bond holders are in the most precarious situation. Even with a rescue package, GM bond holders will likely be taken out at yet-to-be-determined cents on the dollar. It is unlikely that GM bond holders will receive par.
Also, bonds of the auto finance companies (Ford Motor Credit and GMAC)are not obligations of Ford and GM. They are obligations of themselves only. This may not mean much for Ford Motor Credit bond holders as Ford is not in immediate danger of halting vehicle production, but GMAC holders have reason to be concerned. If GM would cease production, GMAC would be left without a product which to finance and GMAC could default as well.
GMAC bond holders do have a reason for which to be hopeful. GMAC has applied to be a bank holding company. If GMAC is approved as a bank holding company, it would be eligible for TARP funds and would continue paying its debt. However, it is unlikely that the FDIC would grant bank holding company status until the GM situation is resolved. If GM would implode taking GMAC with it, GMAC would be an FDIC problem The FDIC has enough problems. However, if GM is "rescued" GMAC bonds could pay as expected even if GM bonds are settled at cents on the dollar. It;s up to the boys and girls in DC.
Speaking of DC, there has been a lively debate in preferred trading circles as to whether the non-cumulative preferred stocks are more attractive than their cumulative trust preferred brethren. The argument for preferred stocks is that they are DRD and QDI eligible and that since they are on par with the government's preferreds, they are unlikely to experience a cessation of dividend payments as the government will demand payment of its dividends. I do not agree.
First: QDI is going away by 2011 and taxes are not a primary concern among preferred investors at this time.
Second: Being on par with the government's preferreds is precisely what makes preferred stocks less secure. If the government would tell a bank to halt payments to the government to save cash, preferred stock dividends would have to be suspended as well. The same would be true if the government began administering a bank. Note: in spite of being administered by the government, AIG's AFF and AVF preferreds ae scheduled to pay their dividends as they are trust structures. Had they been tradtional preferred stocks, the dividends would have been wiped out along with the equity dividends. After consulting other preferred market participants and research and strategy experts, the consensus of the more knowledgeable people is that preferred investors should consider trust preferreds over traditional preferreds as the reward of 200 basis points +/- offered by traditional preferreds is not sufficient for the risk encountered.
The economy is stuck in a negative feedback loop. Weak home sales, scarce credit and financial industry layoffs have causes a slackening of consumer demand. Weaker consumer demand has resulted in job losses in the broader economy which causes more loan and credit card delinquencies which leads to more financial job losses, tighter credit and weaker consumer demand.
Where does this all end? It ends when home prices are permitted to bottom and the sooner the better. If home prices were permitted to bottom sooner, home values may not have fallen as much as they have and how much they are going to fall. Why would letting home prices bottom earlier, rather than attempting the cushion the blow, have resulted in a relatively more modest decline in home prices?
The Fed has the power to make bank borrowing less expensive. It cannot force banks to lower mortgage rates in lock stop (technically it has no power to force banks to lower rates at all) and it has no power to order banks to lower lending standards from their current stringent standards. As credit remains tight it fosters the aforementioned negative feedback loop. As the feedback loop persists (or worsens) and workers lose their jobs, the pool of potential home buyers persists. Demand for homes softens and, quite possibly, many home owners who did not make poor borrowing decisions and who did not purchase too much home begin to go delinquent or default on their mortgages. The result is persistently lower home prices. The recession cannot be reversed until home prices stop falling and job losses are halted.
This brings us to a "chicken and the egg" scenario. Will job losses moderate when home prices stabilize or will home prices stabilize when job losses moderate? The answer is the former. The U.S. economy is consumer driven. Get consumers (home buyers) back in the game and the employment situation will stabilize. Home prices should be permitted to fall to levels which the current pool of qualifying home buyers will enter the market. This had better occur before the pool shrinks further.
Yesterday's Nonfarm Payrolls report indicating a loss of 533,000 jobs (with a significant downward revision to the prior report) may help speed along Detroit Three rescue plans. The Wall Street Journal is reporting that Congress may be close to passing emergency funding to tide the Detroit Three over until January. Although it is possible that the Detroit Three will survive intact until the start of 2009, it is unlikely that they will receive cash to do what they will. Bond holder show=uld beware, but the Detroit Three bonds are not similar situations.
First: Outstanding Chrysler Financial and DaimlerChrysler bonds are obligations of Daimler, not Chrysler. These bonds are not in danger of default. There is one Chrysler 12.25% bond outstanding which is an obligation of Chrysler, but that was a private placement deal, I believe.
2) Ford is not in imminent danger of defaulting in the near future so there is more time to to work out an assistance package.
3) GM needs help NOW!!! GM bond holders are in the most precarious situation. Even with a rescue package, GM bond holders will likely be taken out at yet-to-be-determined cents on the dollar. It is unlikely that GM bond holders will receive par.
Also, bonds of the auto finance companies (Ford Motor Credit and GMAC)are not obligations of Ford and GM. They are obligations of themselves only. This may not mean much for Ford Motor Credit bond holders as Ford is not in immediate danger of halting vehicle production, but GMAC holders have reason to be concerned. If GM would cease production, GMAC would be left without a product which to finance and GMAC could default as well.
GMAC bond holders do have a reason for which to be hopeful. GMAC has applied to be a bank holding company. If GMAC is approved as a bank holding company, it would be eligible for TARP funds and would continue paying its debt. However, it is unlikely that the FDIC would grant bank holding company status until the GM situation is resolved. If GM would implode taking GMAC with it, GMAC would be an FDIC problem The FDIC has enough problems. However, if GM is "rescued" GMAC bonds could pay as expected even if GM bonds are settled at cents on the dollar. It;s up to the boys and girls in DC.
Speaking of DC, there has been a lively debate in preferred trading circles as to whether the non-cumulative preferred stocks are more attractive than their cumulative trust preferred brethren. The argument for preferred stocks is that they are DRD and QDI eligible and that since they are on par with the government's preferreds, they are unlikely to experience a cessation of dividend payments as the government will demand payment of its dividends. I do not agree.
First: QDI is going away by 2011 and taxes are not a primary concern among preferred investors at this time.
Second: Being on par with the government's preferreds is precisely what makes preferred stocks less secure. If the government would tell a bank to halt payments to the government to save cash, preferred stock dividends would have to be suspended as well. The same would be true if the government began administering a bank. Note: in spite of being administered by the government, AIG's AFF and AVF preferreds ae scheduled to pay their dividends as they are trust structures. Had they been tradtional preferred stocks, the dividends would have been wiped out along with the equity dividends. After consulting other preferred market participants and research and strategy experts, the consensus of the more knowledgeable people is that preferred investors should consider trust preferreds over traditional preferreds as the reward of 200 basis points +/- offered by traditional preferreds is not sufficient for the risk encountered.
Wednesday, December 3, 2008
You Better Listen What The Man Says
On November 7th I published the following:
"The easiest way would be to either de-unionize or reach an agreement with the UAW to restructure compensation packages. However, this is unlikely and GM is in such dire need of cash, it may be too late for mere concessions. The best answer for GM (and possibly Ford and Chrysler as well) may be a prepackaged bankruptcy."
The Wall Street Journal is reporting that the experts consulting Congress are recommending pre-packaged bankruptcies for GM and, possibly, Chrysler. The sad fact is that it is very unlikely that the Detroit Three will be able to recover without some protection from its creditors (or at least some debt relief). Whether or not the result is a bankruptcy in the legal sense remains to be seen, but even a government assistance package will probably result in the Detroit Three (especially GM and Chrysler)renegotiating terms with their creditors, suppliers and the UAW.
In fact, the first steps have already been taken. Today,the UAW agreed to delay billions of dollars in employer payments to funds which cover benefits for retirees. The UAW also agreed to eliminate the Jobs Bank. Not having to pay idled workers 95% of their compensation will be a tremendous help. Making deals with creditors will be next.
As part of the plan to appease Congress, automakers have been trying to top each other by announcing aggressive plans to build green cars, mostly hybrids and fully-electric vehicles. Actually going this route, regardless of consumer demand, could put the Detroit Three back in DC begging for money a few years down the road. The automakers need to be as flexible as possible to meet ever-changing consumer demand and tastes. That (and superior quality) has been the secret to success for Detroit's foreign-owned competitors. However, having to bow to government edicts is the price of begging for cash. Let's hope that the Detroit three do not end up like British Leyland.
"The easiest way would be to either de-unionize or reach an agreement with the UAW to restructure compensation packages. However, this is unlikely and GM is in such dire need of cash, it may be too late for mere concessions. The best answer for GM (and possibly Ford and Chrysler as well) may be a prepackaged bankruptcy."
The Wall Street Journal is reporting that the experts consulting Congress are recommending pre-packaged bankruptcies for GM and, possibly, Chrysler. The sad fact is that it is very unlikely that the Detroit Three will be able to recover without some protection from its creditors (or at least some debt relief). Whether or not the result is a bankruptcy in the legal sense remains to be seen, but even a government assistance package will probably result in the Detroit Three (especially GM and Chrysler)renegotiating terms with their creditors, suppliers and the UAW.
In fact, the first steps have already been taken. Today,the UAW agreed to delay billions of dollars in employer payments to funds which cover benefits for retirees. The UAW also agreed to eliminate the Jobs Bank. Not having to pay idled workers 95% of their compensation will be a tremendous help. Making deals with creditors will be next.
As part of the plan to appease Congress, automakers have been trying to top each other by announcing aggressive plans to build green cars, mostly hybrids and fully-electric vehicles. Actually going this route, regardless of consumer demand, could put the Detroit Three back in DC begging for money a few years down the road. The automakers need to be as flexible as possible to meet ever-changing consumer demand and tastes. That (and superior quality) has been the secret to success for Detroit's foreign-owned competitors. However, having to bow to government edicts is the price of begging for cash. Let's hope that the Detroit three do not end up like British Leyland.
Tuesday, December 2, 2008
The Lowrider
Treasury yields continue to decline, including long-term treasury yields. It is easy to figure out why short- term yields are falling (Fed easing), but why long-term yields? Long-term yields usually respond to inflation expectations. As inflation expectations wane, yields fall. However, there is more than inflation expectations at work here. The Fed has stated that it may buy long-term treasuries to push mortgage rates lower. This has caused average life and duration estimates on mortgage-backed securities to decline as refinancing becomes an increased possibility.
MBS traders and large investors typically hedge by buying or selling long-term treasuries. As mortgage rates or rate expectations and duration falls, traders must hedge by increasing duration in their portfolios. They due this by purchasing long-term treasuries. How much of the expected Fed actions are built in to today's treasury yields remain to be seen, but it would not surprise me to see a 30-year government bond yield below 3.00%. Heck, that is only another 20 basis points.
MBS traders and large investors typically hedge by buying or selling long-term treasuries. As mortgage rates or rate expectations and duration falls, traders must hedge by increasing duration in their portfolios. They due this by purchasing long-term treasuries. How much of the expected Fed actions are built in to today's treasury yields remain to be seen, but it would not surprise me to see a 30-year government bond yield below 3.00%. Heck, that is only another 20 basis points.
Monday, December 1, 2008
For What It's Worth
There's something happening here.
Another retail-unfriendly development comes from GMAC (the people who brought you Rescap, Ditech and the low-documentation mortgage. GMAC is offering an exchange of certain senior debt issues if investors accept new bonds, preferreds, etc. Many news stories have correctly noted that GMAC Smartnotes are eligible for the exchange. The has caused the press to criticize GMAC for favoring institutional investors over small investors. However, it goes beyond Smartnotes. Retail investors who own eligible bonds are not able to participate in the exchange either. This really leaves Mom and Pop out in the cold. Although retail investors will get par if their bonds mature on schedule, if GMAC would file for bankruptcy protection, retail investors could receive very little in the way of recovery as the new bonds being given to investors by way of the exchange are senior to existing senior bonds.
As if the auto industry needed more negative press, screwing Mom and Pop will not help its cause. If GMAC files for bankruptcy, retail GMAC bondholders could receive less than current trading levels. Investors should at least monitor this situation closely and may want to consider selling their GMAC bonds with maturities beyond the next few months.
Another retail-unfriendly development comes from GMAC (the people who brought you Rescap, Ditech and the low-documentation mortgage. GMAC is offering an exchange of certain senior debt issues if investors accept new bonds, preferreds, etc. Many news stories have correctly noted that GMAC Smartnotes are eligible for the exchange. The has caused the press to criticize GMAC for favoring institutional investors over small investors. However, it goes beyond Smartnotes. Retail investors who own eligible bonds are not able to participate in the exchange either. This really leaves Mom and Pop out in the cold. Although retail investors will get par if their bonds mature on schedule, if GMAC would file for bankruptcy protection, retail investors could receive very little in the way of recovery as the new bonds being given to investors by way of the exchange are senior to existing senior bonds.
As if the auto industry needed more negative press, screwing Mom and Pop will not help its cause. If GMAC files for bankruptcy, retail GMAC bondholders could receive less than current trading levels. Investors should at least monitor this situation closely and may want to consider selling their GMAC bonds with maturities beyond the next few months.
Tuesday, November 25, 2008
Guranteed To Blow Your Mind
Today, my colleagues and I received many calls regarding the new FDIC-Guaranteed Goldman Sachs three-year bond. There seems to be some confusion about the structure. Let me try to make sense (that sounds familiar) of the structure.
Goldman Sachs issued a three-year note with an explicit FDIC guarantee. This means that the bonds a directly and explicitly backed by the U.S. government. Although this is an attractive feature, the guarantee comes at a price. In this case, the price is a relatively-low yield. The bond carries a coupon of 3.25% and was trading around +190 basis points over the current three-year treasury note (about 3.20%) late this afternoon. This was shocking to many financial advisers and their clients. After all, three-year CDs are offering yields approaching 4.00%. Put a half of a point sales credit on top and the Goldman bond yields approximately 2.90%. Why does the FDIC-guaranteed Goldman bond trade at yields which are far below CD yields? It is a function of the market.
The Goldman bond was an institutional deal. Institutions do not purchase CDs as their trade sizes (5mm, 10mm or more) are well beyond the FDIC limits (now $250,000). Since, in the case of the Goldman issue, it is the bond and not the investors which is insured, size does not matter. This makes yields in the low 3.00% area attractive for institutions with conservative risk tolerance levels.
More deals are in the pipeline. GE, JPM MS and a certain large bank are said to be poised to enter the market with FDIC-backed bonds. Look for yields to be unattractive versus CDs. Also, do not expect to receive allocations when indicating interest in these deals in syndicate. Institutions will have these oversubscribed well before price guidance is posted. Also, in the cases of JPM, MS and that certain large bank will likely run their own books as Goldman did. This means that institutional clients of the issuing firm will receive preference.
Yesterday, I mentioned that FDIC-guaranteed corporate bonds carry a stronger government guarantee than Freddie and Fannie bonds and that could divert investment dollars from the GSEs to the new FDIC-backed corporate bonds which could increase GSE borrowing costs and, therefore, mortgage rates. Today the government responded. The Federal Reserve Bank will purchase up to $100 billion in direct obligations (agency bonds) of FHLMC, FNMA and FHLB. It will also purchase up to $500 billion of mortgage-backed securities issued by FHLMC, FNMA and GNMA.
Finally, the Fed is addressing the real problem. Banks cannot lend unless they can securitize the loans and recoup capital to continue lending. This cannot occur if buyers for MBS are scarce. The Fed's stepping in for buyers could be a win / win situation. Banks can begin lending again as they have buyers for their MBS and the Fed owns MBS consisting of GSE-conforming loans which are not laden with hidden land mines. This could be a money-maker for taxpayers.
The Fed is also going to institute a $200 billion program which will purchase receivables consisting of consumer debt and business loans. This collateral is as safe as GSE-conforming mortgages, but the higher coupons and straightforward structures could also be money makers. This should have been among the earliest actions by the Fed. Fed Chairman Bernanke actually discussed such programs when outlining possible Fed responses to a financial crisis when he was a Fed governor six years ago. What took you so long, Ben?
Goldman Sachs issued a three-year note with an explicit FDIC guarantee. This means that the bonds a directly and explicitly backed by the U.S. government. Although this is an attractive feature, the guarantee comes at a price. In this case, the price is a relatively-low yield. The bond carries a coupon of 3.25% and was trading around +190 basis points over the current three-year treasury note (about 3.20%) late this afternoon. This was shocking to many financial advisers and their clients. After all, three-year CDs are offering yields approaching 4.00%. Put a half of a point sales credit on top and the Goldman bond yields approximately 2.90%. Why does the FDIC-guaranteed Goldman bond trade at yields which are far below CD yields? It is a function of the market.
The Goldman bond was an institutional deal. Institutions do not purchase CDs as their trade sizes (5mm, 10mm or more) are well beyond the FDIC limits (now $250,000). Since, in the case of the Goldman issue, it is the bond and not the investors which is insured, size does not matter. This makes yields in the low 3.00% area attractive for institutions with conservative risk tolerance levels.
More deals are in the pipeline. GE, JPM MS and a certain large bank are said to be poised to enter the market with FDIC-backed bonds. Look for yields to be unattractive versus CDs. Also, do not expect to receive allocations when indicating interest in these deals in syndicate. Institutions will have these oversubscribed well before price guidance is posted. Also, in the cases of JPM, MS and that certain large bank will likely run their own books as Goldman did. This means that institutional clients of the issuing firm will receive preference.
Yesterday, I mentioned that FDIC-guaranteed corporate bonds carry a stronger government guarantee than Freddie and Fannie bonds and that could divert investment dollars from the GSEs to the new FDIC-backed corporate bonds which could increase GSE borrowing costs and, therefore, mortgage rates. Today the government responded. The Federal Reserve Bank will purchase up to $100 billion in direct obligations (agency bonds) of FHLMC, FNMA and FHLB. It will also purchase up to $500 billion of mortgage-backed securities issued by FHLMC, FNMA and GNMA.
Finally, the Fed is addressing the real problem. Banks cannot lend unless they can securitize the loans and recoup capital to continue lending. This cannot occur if buyers for MBS are scarce. The Fed's stepping in for buyers could be a win / win situation. Banks can begin lending again as they have buyers for their MBS and the Fed owns MBS consisting of GSE-conforming loans which are not laden with hidden land mines. This could be a money-maker for taxpayers.
The Fed is also going to institute a $200 billion program which will purchase receivables consisting of consumer debt and business loans. This collateral is as safe as GSE-conforming mortgages, but the higher coupons and straightforward structures could also be money makers. This should have been among the earliest actions by the Fed. Fed Chairman Bernanke actually discussed such programs when outlining possible Fed responses to a financial crisis when he was a Fed governor six years ago. What took you so long, Ben?
Monday, November 24, 2008
Now Wait A Minute
Goldman Sachs is first to market with an FDIC-guaranteed bond. No price guidance has been given and it will probably be oversubscribed before that occurs. As with nearly every part of the government's relief efforts, the law of unintended consequences is in force. New corporate bonds for which the issuer pays for the FDIC guarantee may be considered to be more secure than GSE debt.
How can that be you say? FRE and FNM debt DOES NOT carry an explicit government guarantee. Their charters have not been changed. The guarantee is still implied, but is now stronger. FHFA chief Lockhart called the guarantee "affective". Compare that to the FDIC guarantee of corporate debt. That guarantee is explicit (of the FDIC). This could divert investment dollars from GSE bonds (which is sorely needed to restart the mortgage market) to FDIC-guaranteed corporate bonds. The government is about to find out that it can't have its cake and eat it too.
How can that be you say? FRE and FNM debt DOES NOT carry an explicit government guarantee. Their charters have not been changed. The guarantee is still implied, but is now stronger. FHFA chief Lockhart called the guarantee "affective". Compare that to the FDIC guarantee of corporate debt. That guarantee is explicit (of the FDIC). This could divert investment dollars from GSE bonds (which is sorely needed to restart the mortgage market) to FDIC-guaranteed corporate bonds. The government is about to find out that it can't have its cake and eat it too.
Sunday, November 23, 2008
Ch-Ch-Changes
Last week, the Detroit Three CEOs flew into Washington DC (in comparative style) to beg for money. To justify federal aid, Detroit executives were prepared to do, well not much of anything. The CEO consensus was that the Detroit Three are teetering on the brink of bankruptcy because of the credit crunch. Boys, boys, no one is going to buy that. Yes, the credit crunch may have accelerated your demise, but Detroit has been losing market share for 35 years. Few will contest this fact, not even pro-union politicians.
Since last week, Democratic legislators, including Nancy Pelosi and Harry Reid, have called on the Detroit automakers to come back with restructuring plans if they want federal aid. This may not sit well in the Motor City, with management and labor alike. Even President-elect Obama's adviser, David Axelrod is telling Detroit CEOs that plans to return the former "Big Three" to profitability are needed in order to receive taxpayer dollars. This does not bode well for Ron Gettelfinger and the UAW. It may not bode well for GM bondholders either.
There may be a revolt at General Motors. In spite of CEO Rick Wagoner's statements that bankruptcy was not an option, GM's board of directors said that it will consider all options including bankruptcy. This is a vote of no confidence in Mr. Wagoner, in my opinion. Truthfully, it is not likely for GM bondholders to be made whole, regardless of the restructuring plan. Whether it is a Chapter XI filing or a government-led restructuring, bondholders will likely suffer. Bondholders may not be completely wiped out,but will receive (yet-to-be-determined)cents on the dollar. This compensation my not be in the form of cash. New bonds and / or new shares will likely make up most if not all of bondholder recovery.
GMAC bondholders could be made whole, but it is tricky. A GM Chapter XI "could" lead to a GMAC bankruptcy filing, but GMAC could receive TARP funds if it is approved as a bank holding company. If GM is to survive and emerge from bankruptcy, a viable finance unit is a must.
Remember, GM NEVER guaranteed GMAC bonds or vice versa. The same is true of Ford and Ford Motor Credit. Also, all GMAC and Ford Motor Credit Preferreds are actually $25.00 par bonds and rank pari passu to other bonds of equal seniority. Conservative and moderate investors may want to consider exiting GM, GMAC, F and FMCR bonds. Aggressive investors (speculators) should consider the auto finance companies rather than the manufacturers. Equity investors may want to consider swapping into the $25 par bonds to climb higher on the capital structure.
Since last week, Democratic legislators, including Nancy Pelosi and Harry Reid, have called on the Detroit automakers to come back with restructuring plans if they want federal aid. This may not sit well in the Motor City, with management and labor alike. Even President-elect Obama's adviser, David Axelrod is telling Detroit CEOs that plans to return the former "Big Three" to profitability are needed in order to receive taxpayer dollars. This does not bode well for Ron Gettelfinger and the UAW. It may not bode well for GM bondholders either.
There may be a revolt at General Motors. In spite of CEO Rick Wagoner's statements that bankruptcy was not an option, GM's board of directors said that it will consider all options including bankruptcy. This is a vote of no confidence in Mr. Wagoner, in my opinion. Truthfully, it is not likely for GM bondholders to be made whole, regardless of the restructuring plan. Whether it is a Chapter XI filing or a government-led restructuring, bondholders will likely suffer. Bondholders may not be completely wiped out,but will receive (yet-to-be-determined)cents on the dollar. This compensation my not be in the form of cash. New bonds and / or new shares will likely make up most if not all of bondholder recovery.
GMAC bondholders could be made whole, but it is tricky. A GM Chapter XI "could" lead to a GMAC bankruptcy filing, but GMAC could receive TARP funds if it is approved as a bank holding company. If GM is to survive and emerge from bankruptcy, a viable finance unit is a must.
Remember, GM NEVER guaranteed GMAC bonds or vice versa. The same is true of Ford and Ford Motor Credit. Also, all GMAC and Ford Motor Credit Preferreds are actually $25.00 par bonds and rank pari passu to other bonds of equal seniority. Conservative and moderate investors may want to consider exiting GM, GMAC, F and FMCR bonds. Aggressive investors (speculators) should consider the auto finance companies rather than the manufacturers. Equity investors may want to consider swapping into the $25 par bonds to climb higher on the capital structure.
Thursday, November 20, 2008
I Can't Get No Private Capital
When Hank Paulson shocked and surprised me by wiping out GSE preferred dividends. Although I was wrong about "Hammering Hank" wiping out the GSE preferreds, my prediction that it would wipe out the new issue preferred market was right on, unfortunately. The inability for banks to raise Tier-1 capital may be at the root of the selloff of financial stocks. I am not alone in this opinion.
Paul Miller of Friedman, Billings and Ramsey believes that the U.S. government may need to infuse $1.2 trillion into U.S. banks because private investors will not take risk. Adding fuel to the selloff if the lack of transparency regarding banks exposures to bad assets. Mr. Miller writes: "The sheer size of the capital deficiency, coupled with the opaque nature of credit risk, will keep private capital sidelined."
Few financial institutions have been exempt from the recent selloff. Some firms have seen share prices fall to levels which may necessitate a merger or a sale of some divisions. What could possibly be driving this selloff?
Financial institutions have been reluctant to disclose their exposure to toxic assets. No one is quiet sure what assets are held by each bank and what they are worth. Adding to the jitters has been the practice of some banks of labeling toxic assets a "Level III" Level III assets are not marked to market. When banks move assets to the Level III bucket (for a variety of reasons, none of which anyone believes), the assets do not have to be marked to market (or at all). One bank recently move $10s of billions to Level III. That firm's stock price has gotten crushed. My prediction is that by Monday 11/24/08, Wall Street will look very different.
Not surprisingly, GMAC has applied to become a bank holding company. If approved, GMAC would be able to tap TARP. That could give bond holders a stay of execution. Short-term (months) bonds would likely be money good of approval was granted, but unless GM is able to build and sell cars, GMAC's long-term prospects are bleak. There is something else to consider. The FDIC may be reluctant to grant bank holding company status to GMAC before a GM rescue is finalized. This is because if a bank holding, a GMAC failure would be the FDIC's problem. Stay tuned.
Lastly, when commodities prices were roaring and inflation was on the rise, TIPs were a popular investment, even though we would need Carter-esque inflation for TIPs to outperform treasury notes. Now that inflation has dissipated and deflation may be on the horizon, no one wants TIPs. However, now is the time to buy TIPs. I would buy five year TIPs. Break-evens are sufficiently attractive versus the five-year treasury note to make five-year TIPs attractive investments even if we experience muted or even, negative inflation in the near-term.
Paul Miller of Friedman, Billings and Ramsey believes that the U.S. government may need to infuse $1.2 trillion into U.S. banks because private investors will not take risk. Adding fuel to the selloff if the lack of transparency regarding banks exposures to bad assets. Mr. Miller writes: "The sheer size of the capital deficiency, coupled with the opaque nature of credit risk, will keep private capital sidelined."
Few financial institutions have been exempt from the recent selloff. Some firms have seen share prices fall to levels which may necessitate a merger or a sale of some divisions. What could possibly be driving this selloff?
Financial institutions have been reluctant to disclose their exposure to toxic assets. No one is quiet sure what assets are held by each bank and what they are worth. Adding to the jitters has been the practice of some banks of labeling toxic assets a "Level III" Level III assets are not marked to market. When banks move assets to the Level III bucket (for a variety of reasons, none of which anyone believes), the assets do not have to be marked to market (or at all). One bank recently move $10s of billions to Level III. That firm's stock price has gotten crushed. My prediction is that by Monday 11/24/08, Wall Street will look very different.
Not surprisingly, GMAC has applied to become a bank holding company. If approved, GMAC would be able to tap TARP. That could give bond holders a stay of execution. Short-term (months) bonds would likely be money good of approval was granted, but unless GM is able to build and sell cars, GMAC's long-term prospects are bleak. There is something else to consider. The FDIC may be reluctant to grant bank holding company status to GMAC before a GM rescue is finalized. This is because if a bank holding, a GMAC failure would be the FDIC's problem. Stay tuned.
Lastly, when commodities prices were roaring and inflation was on the rise, TIPs were a popular investment, even though we would need Carter-esque inflation for TIPs to outperform treasury notes. Now that inflation has dissipated and deflation may be on the horizon, no one wants TIPs. However, now is the time to buy TIPs. I would buy five year TIPs. Break-evens are sufficiently attractive versus the five-year treasury note to make five-year TIPs attractive investments even if we experience muted or even, negative inflation in the near-term.
Wednesday, November 19, 2008
It's The End Of The World
Time is running out for the Detroit Three, especially GM. Without some form of financial aid, GM may not survive until Congress reconvenes in January. The clock may have struck twelve for GM today as the Senate announced that a vote on aid to the Detroit Three this week.
Up until now I was of the opinion that GM would get some kind of rescue and although GM bondholders may not be made whole, GMAC bondholders may me made whole or, at least receive a recovery at similar levels as recent trading levels. Now I am not so certain. There is too much inflexibility on all sides. Congressional Democrats what the Detroit Three to come back with a plan which returns them to profitability, but preserves all UAW jobs and a mandate to build so-called "green" cars, consumer demand be damned. Detroit CEOs want no meaningful change to their corporate cultures and the UAW will make no further concessions of wages, benefits and job cuts.
Owning GM bonds may be a play on bankruptcy recovery. Owning GMAC bonds is a bet that GM continues to build cars, inside or outside of bankruptcy. What should investors do? If I owned GM bonds I would sell. If I owned GMAC bonds, I would hold on and pray. If I was at or near retirment age, I would drive away laying rubber all the way.
Up until now I was of the opinion that GM would get some kind of rescue and although GM bondholders may not be made whole, GMAC bondholders may me made whole or, at least receive a recovery at similar levels as recent trading levels. Now I am not so certain. There is too much inflexibility on all sides. Congressional Democrats what the Detroit Three to come back with a plan which returns them to profitability, but preserves all UAW jobs and a mandate to build so-called "green" cars, consumer demand be damned. Detroit CEOs want no meaningful change to their corporate cultures and the UAW will make no further concessions of wages, benefits and job cuts.
Owning GM bonds may be a play on bankruptcy recovery. Owning GMAC bonds is a bet that GM continues to build cars, inside or outside of bankruptcy. What should investors do? If I owned GM bonds I would sell. If I owned GMAC bonds, I would hold on and pray. If I was at or near retirment age, I would drive away laying rubber all the way.
Monday, November 17, 2008
Now Wait A Minute
Earlier this year, when the idea of rescuing troubled mortgage borrowers was first bandied about, I questioned the morality and legality of doing so from the standpoint of investors. The vast majority of mortgages are not held by banks, but have been securitized (MBS) and sold to investors. In many instances, banks are merely mortgage servicers.
Investors are questioning the morality of changing the terms on mortgages for which they are creditors. Investors believe that the decision is there's not the banks. I questioned a friend who is a mortgage expert about the legality of banks changing mortgage terms without the consent of investors. He told me last week that most mortgage contracts provide for such changes. An article in today's Wall Street Journal discusses this topic.
The Journal states that a provision known as delegated authority. Unbeknownst to many investors, banks can change the terms of a loan without the consent of investors, who are the actual creditors. Investors believe they should have been consulted nonetheless.
Banks may have the legal right to change the terms of mortgages. Such changes my ultimately benefit investors in the long run, but I am willing to wager that such provisions will keep many investors away from the private label MBS market.
Why just private label MBS? With agency-backed MBS, the agency involved guarantees the return of principal (explicitly government guaranteed with GNMA and implicitly guaranteed by FNMA and FHLMC). With private label MBS, the issuing / servicing bank is not responsible for the return of principal to investors. If enough mortgages default to return 60 cents on the dollar to investors, so be it. Banks to not guarantee their MBS in any way.
As with non-cumulative preferred stock, private label MBS may be another dead market.
Investors are questioning the morality of changing the terms on mortgages for which they are creditors. Investors believe that the decision is there's not the banks. I questioned a friend who is a mortgage expert about the legality of banks changing mortgage terms without the consent of investors. He told me last week that most mortgage contracts provide for such changes. An article in today's Wall Street Journal discusses this topic.
The Journal states that a provision known as delegated authority. Unbeknownst to many investors, banks can change the terms of a loan without the consent of investors, who are the actual creditors. Investors believe they should have been consulted nonetheless.
Banks may have the legal right to change the terms of mortgages. Such changes my ultimately benefit investors in the long run, but I am willing to wager that such provisions will keep many investors away from the private label MBS market.
Why just private label MBS? With agency-backed MBS, the agency involved guarantees the return of principal (explicitly government guaranteed with GNMA and implicitly guaranteed by FNMA and FHLMC). With private label MBS, the issuing / servicing bank is not responsible for the return of principal to investors. If enough mortgages default to return 60 cents on the dollar to investors, so be it. Banks to not guarantee their MBS in any way.
As with non-cumulative preferred stock, private label MBS may be another dead market.
Oops I Did It Again
I have written, many times, that banks are not using capital raised earlier this year to lend to consumers, but to repair their balance sheets. I have also commented on how companies which are unable raise money in the capital markets have been taping bank lines of credit. CIT Group was one notable institution to do this earlier this year. Genworth Financial did the same last Friday. Although these backstop provisions are beneficial to the borrowers, they are putting already battered banks under even more stress. Although I failed to make the connection between reduced consumer lending and corporate lines of credit, an article in today Wall Street Journal has not.
The article details how corporate backstop facilities are putting banks under pressure because banks cannot securitize these loans. The capital markets are dysfunctional at this time. The author makes the case that the government's attention should focus on repairing the capital markets. This is easier said than done at this point in time.
Why is it so difficult? First, the media and certain government officials have made the crisis a battle between Wall Street and Main Street. What many of our leaders do not understand (or won't admit) is that Wall Street and Main Street intersect. Shut down Wall Street and business shuts down on Main Street. The country needs functioning markets.
Secondly, government actions (halting GSE preferred dividend payments, the ever changing TARP plan and inconsistent dealings with troubled institutions, etc.) have only helped to shut down the capital markets to companies needing funding, especially financial institutions.
I agree with the Journal that corporate backstop financing is helping to prevent banks from lending, but this is a result of the credit crisis not a cause. If banks did not have many billions of writedowns from bad assets, the credit markets would not have seized and these corporate loans and lines of credit never would have been tapped. Until the capital markets are unfrozen the crisis will continue.
How to we unfreeze the markets? Here is a crazy idea. Why not insist that banks receiving TARP funds use the funds to pay preferred dividends, bond interest payments and loan to companies needing capital, but which cannot access TARP themselves. After all, not every company can become a bank holding company, although they will try.
Da Do Ron-Ron
UAW chief Ron Gettelfinger announced over the weekend that the UAW will make no further concessions, its workers earn about the same as those working for foreign companies in the U.S. and GM's problems are not the result if the UAW OR management. Rather, it is the result of higher fuel prices (until recently) and the Wall Street credit crunch.
That's right Ron, GM, which has lost money for the last several years and which has been on the decline for over 30 years is in trouble because it cannot issue more debt and afford more 0% financing. Toyota, Honda, Nissan, Subaru, Hyundai, Mercedes and BMW, all which build vehicles and components in the U.S., do not appear to have such problems. The problem, Ron is that UAW workers have benefit packages which far exceed those of workers at foreign-owned factories, GM is saddled with legacy costs (pensions, retiree benefits, etc.) and stupid ideas such as the Jobs bank, which pays workers not to work.
Agreeing to the aforementioned compensation packages is the fault of GM (and Ford and Chrysler) management. GM culture is that the company is THE U.S. automaker and that it will regain market share. I don't think executives get out of Michigan much. Although Detroit vehicles may rule the road in and around Detroit, the are not as dominant in other areas of the country. Many people get by just fine without a mammoth SUV.
Detroit's bloated corporate structures, generous labor agreements and ostrich-like behavior with regards to its competition is dooming Detroit to fail. When one needs to sell small or mid-size car for at least $24,000 (GM's figure as of 2005), one cannot make money in today's environment. The Detroit Three have not made money on passenger cars for many years. The only reasons Detroit continued to build cars along with trucks is because the needed fuel-efficient, albeit obsolete, cars to bring their Corporate Average Fuel Economy (CAFE) numbers down to government-mandated levels. That is right boys and girls, the Detroit Three are forced to build vehicles which are unprofitable to meet government mandates. That and the fact that it would have to pay assembly line workers not to work if car plants were idled force Detroit to build unprofitable cars. If one is not going to profit any way, why bring them up to Toyota or Honda standards. In a perverse way of thinking, it is more cost-effective not to invest in passenger car technology.
Many people have asked me what to do with their GM bonds. As they are trading at prices in the $20 area, I do not think investors are harmed by waiting to see how the situation plays out. However, I do not see any disadvantage to selling now. Sound confusing? Let me explain.
The street is essentially telling us what to expect from bankruptcy recovery. However, in a bankruptcy, bondholders may not receive cash. In a bankruptcy, creditors may receive cash, new stock, new bonds or a combination thereof. Investors wanting cash may want to sell now.
What about a government bailout? Even a government bailout does not guarantee that investors receive par or receive cash. In a bailout, investors will still probably receive cents on the dollar for their bonds and probably will not receive much, if any, cash. Investors may receive more GM bonds and stock in a bailout than they would receive in a traditional bankruptcy, but they may not. What about the government just giving GM (and Ford and Chrysler) cash? Since that doesn't fix the problem, I would recommend that any investors still holding GM bonds to sell into any rallies.
What about GMAC? GMAC has no cross-default responsibilities with GM. There was never any, even before the 51% spin-off to Cerberus (the same is true of Ford and Ford Motor Credit). I am cautiously more optimistic about GMAC. Why am I more optimistic? If there is any hope of rebuilding GM, there needs to be a viable and functioning finance company to fund the purchase of vehicles. GMAC COULD become a bank holding company, but that probably would not happen until (unless) GM is saved in some form. After all, why make GMAC a bank holding company just to have the FDIC (or the OTS if it becomes a thrift) if GM collapsed leaving GMAC without vehicles to finance.
My opinion for GMAC bonds is similar to that for GM bonds with one caveat. I think that GMAC will be in business. As long as GM is producing vehicles (whatever its corporate condition), GMAC should receive TARP money and will make good on its obligations.
What if I am wrong? Those investors who cannot risk a GMAC failure should cash out now, especially into any rallies. The one exception may be GMAC Smartnotes. GMAC Smartnotes (which are senior notes) are trading 10 or more points below other GMAC senior notes. This is due to the lack of liquidity which is a result of small deal sizes. Since Smartnote holders would receive the same recovery as larger senior notes in a bankruptcy and the market is pricing (possible bankruptcy recovery estimates) large senior note issues 10 or more points higher than Smartnotes, investors may wish to ride this out. As always, investor suitability should reign supreme.
The article details how corporate backstop facilities are putting banks under pressure because banks cannot securitize these loans. The capital markets are dysfunctional at this time. The author makes the case that the government's attention should focus on repairing the capital markets. This is easier said than done at this point in time.
Why is it so difficult? First, the media and certain government officials have made the crisis a battle between Wall Street and Main Street. What many of our leaders do not understand (or won't admit) is that Wall Street and Main Street intersect. Shut down Wall Street and business shuts down on Main Street. The country needs functioning markets.
Secondly, government actions (halting GSE preferred dividend payments, the ever changing TARP plan and inconsistent dealings with troubled institutions, etc.) have only helped to shut down the capital markets to companies needing funding, especially financial institutions.
I agree with the Journal that corporate backstop financing is helping to prevent banks from lending, but this is a result of the credit crisis not a cause. If banks did not have many billions of writedowns from bad assets, the credit markets would not have seized and these corporate loans and lines of credit never would have been tapped. Until the capital markets are unfrozen the crisis will continue.
How to we unfreeze the markets? Here is a crazy idea. Why not insist that banks receiving TARP funds use the funds to pay preferred dividends, bond interest payments and loan to companies needing capital, but which cannot access TARP themselves. After all, not every company can become a bank holding company, although they will try.
Da Do Ron-Ron
UAW chief Ron Gettelfinger announced over the weekend that the UAW will make no further concessions, its workers earn about the same as those working for foreign companies in the U.S. and GM's problems are not the result if the UAW OR management. Rather, it is the result of higher fuel prices (until recently) and the Wall Street credit crunch.
That's right Ron, GM, which has lost money for the last several years and which has been on the decline for over 30 years is in trouble because it cannot issue more debt and afford more 0% financing. Toyota, Honda, Nissan, Subaru, Hyundai, Mercedes and BMW, all which build vehicles and components in the U.S., do not appear to have such problems. The problem, Ron is that UAW workers have benefit packages which far exceed those of workers at foreign-owned factories, GM is saddled with legacy costs (pensions, retiree benefits, etc.) and stupid ideas such as the Jobs bank, which pays workers not to work.
Agreeing to the aforementioned compensation packages is the fault of GM (and Ford and Chrysler) management. GM culture is that the company is THE U.S. automaker and that it will regain market share. I don't think executives get out of Michigan much. Although Detroit vehicles may rule the road in and around Detroit, the are not as dominant in other areas of the country. Many people get by just fine without a mammoth SUV.
Detroit's bloated corporate structures, generous labor agreements and ostrich-like behavior with regards to its competition is dooming Detroit to fail. When one needs to sell small or mid-size car for at least $24,000 (GM's figure as of 2005), one cannot make money in today's environment. The Detroit Three have not made money on passenger cars for many years. The only reasons Detroit continued to build cars along with trucks is because the needed fuel-efficient, albeit obsolete, cars to bring their Corporate Average Fuel Economy (CAFE) numbers down to government-mandated levels. That is right boys and girls, the Detroit Three are forced to build vehicles which are unprofitable to meet government mandates. That and the fact that it would have to pay assembly line workers not to work if car plants were idled force Detroit to build unprofitable cars. If one is not going to profit any way, why bring them up to Toyota or Honda standards. In a perverse way of thinking, it is more cost-effective not to invest in passenger car technology.
Many people have asked me what to do with their GM bonds. As they are trading at prices in the $20 area, I do not think investors are harmed by waiting to see how the situation plays out. However, I do not see any disadvantage to selling now. Sound confusing? Let me explain.
The street is essentially telling us what to expect from bankruptcy recovery. However, in a bankruptcy, bondholders may not receive cash. In a bankruptcy, creditors may receive cash, new stock, new bonds or a combination thereof. Investors wanting cash may want to sell now.
What about a government bailout? Even a government bailout does not guarantee that investors receive par or receive cash. In a bailout, investors will still probably receive cents on the dollar for their bonds and probably will not receive much, if any, cash. Investors may receive more GM bonds and stock in a bailout than they would receive in a traditional bankruptcy, but they may not. What about the government just giving GM (and Ford and Chrysler) cash? Since that doesn't fix the problem, I would recommend that any investors still holding GM bonds to sell into any rallies.
What about GMAC? GMAC has no cross-default responsibilities with GM. There was never any, even before the 51% spin-off to Cerberus (the same is true of Ford and Ford Motor Credit). I am cautiously more optimistic about GMAC. Why am I more optimistic? If there is any hope of rebuilding GM, there needs to be a viable and functioning finance company to fund the purchase of vehicles. GMAC COULD become a bank holding company, but that probably would not happen until (unless) GM is saved in some form. After all, why make GMAC a bank holding company just to have the FDIC (or the OTS if it becomes a thrift) if GM collapsed leaving GMAC without vehicles to finance.
My opinion for GMAC bonds is similar to that for GM bonds with one caveat. I think that GMAC will be in business. As long as GM is producing vehicles (whatever its corporate condition), GMAC should receive TARP money and will make good on its obligations.
What if I am wrong? Those investors who cannot risk a GMAC failure should cash out now, especially into any rallies. The one exception may be GMAC Smartnotes. GMAC Smartnotes (which are senior notes) are trading 10 or more points below other GMAC senior notes. This is due to the lack of liquidity which is a result of small deal sizes. Since Smartnote holders would receive the same recovery as larger senior notes in a bankruptcy and the market is pricing (possible bankruptcy recovery estimates) large senior note issues 10 or more points higher than Smartnotes, investors may wish to ride this out. As always, investor suitability should reign supreme.
Saturday, November 15, 2008
I Can't Stand It
Ron (don't blame us) Gettelfinger, of the UAW, has publicly stated today that the UAW will make no further concessions with regards to a Detroit bailout. In a noticeable change of rhetoric, Mr. Gettelfinger is not blaming Detroit management either. Instead, Mr. Gettelfinger's bogey men are Wall Street and high gasoline prices. Never mind that GM has not made money from U.S. automotive operations in years, instead relying on foreign sales and profits from GMAC. GM was forced to resort to 0% financing in 2002, before high fuel prices. Some may argue that the economy was sluggish in 2002. OK, What about 2003 to 2006? The economy was booming, borrowing costs were low and fuel prices, although somewhat high, were no higher than today's prices and much lower than their peak earlier this year. What about the fact that Detroit's domestic competitors are weathering the storm just fine.
No the bottom line is that the Detroit Three, for years, caved in to UAW demands for ever-higher wages and better benefit packages. To pay for these union contracts, the Detroit Three were forced to depend on high-margin vehicles such as trucks and SUVs. For years, experts were concerned that the Detroit Three were too dependent on one kind of product and did not have the needed flexibility to successfully meet changing consumer demands. They were right. Today's Detroit dilemma is complete the fault of Detroit management and the UAW. If they remain rigid they will die. If not now (government money), then down the road when irate customers join he millions of customers who have already left the Detroit Three forever. This Detroit vehicle owner is poised to do the same.
Here is a CNN / Money story from January 16th 2002:
http://money.cnn.com/2002/01/16/companies/gm/
No the bottom line is that the Detroit Three, for years, caved in to UAW demands for ever-higher wages and better benefit packages. To pay for these union contracts, the Detroit Three were forced to depend on high-margin vehicles such as trucks and SUVs. For years, experts were concerned that the Detroit Three were too dependent on one kind of product and did not have the needed flexibility to successfully meet changing consumer demands. They were right. Today's Detroit dilemma is complete the fault of Detroit management and the UAW. If they remain rigid they will die. If not now (government money), then down the road when irate customers join he millions of customers who have already left the Detroit Three forever. This Detroit vehicle owner is poised to do the same.
Here is a CNN / Money story from January 16th 2002:
http://money.cnn.com/2002/01/16/companies/gm/
Thursday, November 13, 2008
Shut Up-A You Face
Yesterday, Treasury Secretary Hank Paulson (A.K.A. Mr. Flip Flop) announced that he was cancelling plans for the Treasury to buy troubled assets from banks. The markets were shocked by the sudden change of heart. I was not.
Although I was surprised by his timing (middle of a trading session with no warning, I was not surprised by the change of plans. After all, banks are not going to sell assets at 50 cents on the dollar (they may as well write them down and hope for some degree of recovery) and the Treasury was not going to pay par (or anything close to it) to assets which glow in the dark. The TARP plan was still-born. However, following the markets' negative reaction and criticism from Congress, Mr. Paulson stated today that purchasing troubled assets are not off the table.
Please Mr. Paulson, do not open your mouth until you are certain of what you speak. I appreciate that we are in uncharted territory and that Mr. Paulson and Mr. Bernanke often have to make things up as they go along, but opening one's mouth and unnerving the markets when one is not sure is counterproductive. Mr. Paulson is scaring market particpants and he must stop now!!!
I do not envy Mr. Paulson. He is dealing with the most severe financial crisis since thhe great depression, but his policy reversals (the GSEs) and inconsistencies (Bear Stearns, Lehman, AIG, etc.) have the markets frightened instead of calmed by his actions.
I am frightened. After being blown up by Mr. Paulson's handling of the GSE preferreds, I am determined not to be burned again. In my opinion, investors looking to buy into firms receiving government capital injections would be better served by buying trust preferreds or bonds rather than common equity or preferred stock. The government's level of investment is equal traditional non-cumulative preferreds and senior to common. In other words, Mr, Paulson can wipe out the dividends on common and preferred stock if he deems it necessary. He needs only to order banks not to pay the government the dividends on the government's preferreds. Securities of equal and lower ranks would also have to have dividends suspended. This coupled with the strong possibility of having the 15% tax on dividends raised makes traditonal preferreds unattarctive in my view. Trust preferreds and bonds are senior to the government's claim. Stay senior to Hank!!!
Although I was surprised by his timing (middle of a trading session with no warning, I was not surprised by the change of plans. After all, banks are not going to sell assets at 50 cents on the dollar (they may as well write them down and hope for some degree of recovery) and the Treasury was not going to pay par (or anything close to it) to assets which glow in the dark. The TARP plan was still-born. However, following the markets' negative reaction and criticism from Congress, Mr. Paulson stated today that purchasing troubled assets are not off the table.
Please Mr. Paulson, do not open your mouth until you are certain of what you speak. I appreciate that we are in uncharted territory and that Mr. Paulson and Mr. Bernanke often have to make things up as they go along, but opening one's mouth and unnerving the markets when one is not sure is counterproductive. Mr. Paulson is scaring market particpants and he must stop now!!!
I do not envy Mr. Paulson. He is dealing with the most severe financial crisis since thhe great depression, but his policy reversals (the GSEs) and inconsistencies (Bear Stearns, Lehman, AIG, etc.) have the markets frightened instead of calmed by his actions.
I am frightened. After being blown up by Mr. Paulson's handling of the GSE preferreds, I am determined not to be burned again. In my opinion, investors looking to buy into firms receiving government capital injections would be better served by buying trust preferreds or bonds rather than common equity or preferred stock. The government's level of investment is equal traditional non-cumulative preferreds and senior to common. In other words, Mr, Paulson can wipe out the dividends on common and preferred stock if he deems it necessary. He needs only to order banks not to pay the government the dividends on the government's preferreds. Securities of equal and lower ranks would also have to have dividends suspended. This coupled with the strong possibility of having the 15% tax on dividends raised makes traditonal preferreds unattarctive in my view. Trust preferreds and bonds are senior to the government's claim. Stay senior to Hank!!!
Tuesday, November 11, 2008
Come To Butt-Head
In my previous post, I advocated that GM consider a pre-packaged bankruptcy. In an example or great minds think alike (or maybe it is fools never disagree), noted hedge fund manager Bill Ackman apparently agrees with yours truly and also advocates a pre-packaged bankruptcy for GM. Mr Ackman states:
"It (GM) has been hamstrung for years because it has too much debt and
it has contracts that are uneconomic. The way to solve that problem is not to lend more money. They should do prepackaged bankruptcy."
Nancy Pelosi has other ideas. She wants to throw money at the so-called "Detroit Three". Her idea to protect taxpayers is to limit executive compensation, but will not ask the UAW to give any concessions. Although I am no fan of Detroit mismanagement, UAW contracts are way out of line with the rest of the country and need to fall in line. Ideology aside, the Detroit Three's labor costs are not mathematically feasible. There is no way around the math, like it or not. Look for a big fight in DC with GM's life on the line. The fight could change the nature of all government bailouts. Ding, round one!
"It (GM) has been hamstrung for years because it has too much debt and
it has contracts that are uneconomic. The way to solve that problem is not to lend more money. They should do prepackaged bankruptcy."
Nancy Pelosi has other ideas. She wants to throw money at the so-called "Detroit Three". Her idea to protect taxpayers is to limit executive compensation, but will not ask the UAW to give any concessions. Although I am no fan of Detroit mismanagement, UAW contracts are way out of line with the rest of the country and need to fall in line. Ideology aside, the Detroit Three's labor costs are not mathematically feasible. There is no way around the math, like it or not. Look for a big fight in DC with GM's life on the line. The fight could change the nature of all government bailouts. Ding, round one!
Friday, November 7, 2008
American Leyland
Today, GM reported huge losses ($2.5B in the third quarter) and stated that it burned through $6.9 billion. According to the company, its cash reserves now stand at $16.2B. GM says that it needs between $11 billion and $15 billion to fund operations. The company expressed concerns that it may not have enough cash to survive the balance of the year, which has just over a month and a half remaining. GM needs help (as do Ford and Chrysler) and it needs it now!
The way which is probably preferred (to varying degrees) is throwing cash at the Detroit Three is an attempt to weather the storm to maintain the status quo in Detroit. In exchange for this cash infusion, it has been suggested that the government could take an ownership interest in the Detroit automakers. This hearkens back to the thrilling days of British Leyland.
British Leyland was formed in 1968 by combining Britain's automakers. I was partially nationalized in 1975 in an attempt to keep its unionized workforce employed. Strikes, mismanagement and high labor costs eventually doomed British Leyland. Companies such as MG, Austin Healey and and Triumph passed into history and iconic brands such as Jaguar and Land Rover were sold to foreign automakers. It was an unmitigated disaster. This is probably fate which awaits a merged Detroit Three with a semi0nationalization thrown in for good measure. All is not lost however. There are ways to save the Detroit Three.
The fact of life is that Ford and GM are too big. They need to downsize and trim their labor forces. All of the Big Three need to adjust their compensation structures, both blue-collar and white-collar, to resemble those of employees of foreign manufacturers in America. After all, Toyota, Nissan, Honda, Hyundai, Subaru, BMW and Mercedes build cars and components in the U.S.
The easiest way would be to either de-unionize or reach an agreement with the UAW to restructure compensation packages. However, this is unlikely and GM is in such dire need of cash, it may be too late for mere concessions. The best answer for GM (and possibly Ford and Chrysler as well) may be a prepackaged bankruptcy.
The criticism of filing for bankruptcy is that potential car buyers may stay away out of fear that their warranties may not be honored and parts availability and service may be compromised. A prepackaged bankruptcy solves this problem.
In a prepackaged bankruptcy, a company reaches agreements with its creditors, suppliers and labor unions prior to filing for bankruptcy protection. The company will also obtain Debtor In Possession financing to pay for any restructuring costs. A company can go in and out of bankruptcy almost instantly.
One obstacle (apart from the UAW) is that few if any investors would be interested in providing DIP financing. Here is where the government can help. If the government merely provided the DIP loans (similar to Chrysler in the late 1970s, although Chrysler avoided bankruptcy, such a deal could be done. GM could be out from under billions of dollars of debt, it would be smaller, leaner and have more manageable labor agreements and be a healthier customer for its suppliers. This is the best way to preserve the Detroit Three and save as many jobs as possible.
Unfortunately, the UAW and its allies in DC would probably shoot this idea down (they don't see labor as a commodity whose demand can wax and wane along with compensation levels). At worst, GM and, maybe Ford and Chrysler as well, will fade into history. At best, we will have "American Leyland" and the U.S. auto industry's demise will be further prolonged.
The way which is probably preferred (to varying degrees) is throwing cash at the Detroit Three is an attempt to weather the storm to maintain the status quo in Detroit. In exchange for this cash infusion, it has been suggested that the government could take an ownership interest in the Detroit automakers. This hearkens back to the thrilling days of British Leyland.
British Leyland was formed in 1968 by combining Britain's automakers. I was partially nationalized in 1975 in an attempt to keep its unionized workforce employed. Strikes, mismanagement and high labor costs eventually doomed British Leyland. Companies such as MG, Austin Healey and and Triumph passed into history and iconic brands such as Jaguar and Land Rover were sold to foreign automakers. It was an unmitigated disaster. This is probably fate which awaits a merged Detroit Three with a semi0nationalization thrown in for good measure. All is not lost however. There are ways to save the Detroit Three.
The fact of life is that Ford and GM are too big. They need to downsize and trim their labor forces. All of the Big Three need to adjust their compensation structures, both blue-collar and white-collar, to resemble those of employees of foreign manufacturers in America. After all, Toyota, Nissan, Honda, Hyundai, Subaru, BMW and Mercedes build cars and components in the U.S.
The easiest way would be to either de-unionize or reach an agreement with the UAW to restructure compensation packages. However, this is unlikely and GM is in such dire need of cash, it may be too late for mere concessions. The best answer for GM (and possibly Ford and Chrysler as well) may be a prepackaged bankruptcy.
The criticism of filing for bankruptcy is that potential car buyers may stay away out of fear that their warranties may not be honored and parts availability and service may be compromised. A prepackaged bankruptcy solves this problem.
In a prepackaged bankruptcy, a company reaches agreements with its creditors, suppliers and labor unions prior to filing for bankruptcy protection. The company will also obtain Debtor In Possession financing to pay for any restructuring costs. A company can go in and out of bankruptcy almost instantly.
One obstacle (apart from the UAW) is that few if any investors would be interested in providing DIP financing. Here is where the government can help. If the government merely provided the DIP loans (similar to Chrysler in the late 1970s, although Chrysler avoided bankruptcy, such a deal could be done. GM could be out from under billions of dollars of debt, it would be smaller, leaner and have more manageable labor agreements and be a healthier customer for its suppliers. This is the best way to preserve the Detroit Three and save as many jobs as possible.
Unfortunately, the UAW and its allies in DC would probably shoot this idea down (they don't see labor as a commodity whose demand can wax and wane along with compensation levels). At worst, GM and, maybe Ford and Chrysler as well, will fade into history. At best, we will have "American Leyland" and the U.S. auto industry's demise will be further prolonged.
Thursday, November 6, 2008
Don't Stop Believing
I have had many questions asking why the markets, especially financial bonds and preferreds, have not responded more positively to the government's rescue plans. My answer has been that the market does not trust that the government will infuse money and take a passive role. Recent comments from legislators have only heightened these fears. Some of my readers have doubted my belief that the government (thanks to its treatment of the GSEs and Lehman) has caused more fear instead of easing investors concerns. Maybe the following excerpt from the Wall Street Journal is more convincing:
"A survey of more than 400 firms by Sifma and other financial-industry trade groups found that a large percentage of financial firms would be reluctant to participate without more details about any potential program. More than nine in 10 said they were less likely to participate in the so-called Troubled Asset Relief Program because of a "lack of clarity." Nearly the same number expressed reluctance if Treasury requires firms to issue warrants in return for taking assets from them."
No one trusts the government, not the banks and not investors. Banks want the government to buy toxic assets at reasonably high prices without becoming beholden to the government. Investors want to be assured that banks have accounted for all of their toxic assets and that the government will not force a suspension of dividends or other actions which would be negative for their investments.
What is frightening to me is that the banks are so adamant that the government get these assets of their books. They don't want accounting rule changes. They don't want cash infusions due to preferred or warrant sales. They want the government to take bad assets at good prices. Oppenheimer's Meredith Whitney may frighten the heck out of us, but I believe her to be on the money. Look for more pain down the road.
"A survey of more than 400 firms by Sifma and other financial-industry trade groups found that a large percentage of financial firms would be reluctant to participate without more details about any potential program. More than nine in 10 said they were less likely to participate in the so-called Troubled Asset Relief Program because of a "lack of clarity." Nearly the same number expressed reluctance if Treasury requires firms to issue warrants in return for taking assets from them."
No one trusts the government, not the banks and not investors. Banks want the government to buy toxic assets at reasonably high prices without becoming beholden to the government. Investors want to be assured that banks have accounted for all of their toxic assets and that the government will not force a suspension of dividends or other actions which would be negative for their investments.
What is frightening to me is that the banks are so adamant that the government get these assets of their books. They don't want accounting rule changes. They don't want cash infusions due to preferred or warrant sales. They want the government to take bad assets at good prices. Oppenheimer's Meredith Whitney may frighten the heck out of us, but I believe her to be on the money. Look for more pain down the road.
Tuesday, November 4, 2008
Sweet dreams and flying machines in pieces on the ground.
Election day is finally here. Both candidates have seen fire and rain throughout the contest. Voters have endured much as well. Depending who wins the election, some of my readers may feel as though the future appears bleak. Let's put things into proper perspective. We are choosing between two candidates, elected democratically, who will (in their own way) preserve the freedoms to which we are guaranteed. We need not worry about a despot assuming power or a rolling back of our civil rights. Compared with much of the rest of the world, we do not have much about which to worry. Our problems and concerns are trivial to that of much of the world. We may have much to lose, but this is only because we have so much to lose.
Enough with the civics lesson. Tomorrow we all have to make a living and protect our clients. Depending on which candidate wins and how much of a Democratic majority of Congress, there could be more government intervention or influence on banks, lenders and insurance companies.
Ever since Treasury Secretary Paulson (with pressure from Barney Frank and Chris Dodd), wiped out the GSE preferreds, the markets have been very wary of government "help" My concern is that the next administration and Congress may change the rules of the TARP plan.
The government has the power to dictate how government funds are used by the banks. This includes forcing banks to use funds to issue more loans and force banks to suspend dividends on common and preferred equity. It is because dividends of assisted institutions will be paid only with the blessing of the government, I suggest buying trust preferreds, which have a debt component, rather than DRD/QDI preferreds. Because of their debt component, trust preferreds are SENIOR to the preferreds being purchased by the government. If you trust the government, feel free to buy non-cumulative preferreds. I would rather stay senior to Uncle Sam, thank you.
By the way, I am not alone with my concerns about the Government intervention. The following is from an article in today's online Wall Street Journal:
"Any expansion would likely prompt calls by U.S. lawmakers to attach more conditions. Members of Congress have begun pushing Treasury to force banks to lend the money they've received, complaining to Mr. Paulson that they're sitting on the cash or using it to fund acquisitions and pay dividends."
Caveat Emptor!
Enough with the civics lesson. Tomorrow we all have to make a living and protect our clients. Depending on which candidate wins and how much of a Democratic majority of Congress, there could be more government intervention or influence on banks, lenders and insurance companies.
Ever since Treasury Secretary Paulson (with pressure from Barney Frank and Chris Dodd), wiped out the GSE preferreds, the markets have been very wary of government "help" My concern is that the next administration and Congress may change the rules of the TARP plan.
The government has the power to dictate how government funds are used by the banks. This includes forcing banks to use funds to issue more loans and force banks to suspend dividends on common and preferred equity. It is because dividends of assisted institutions will be paid only with the blessing of the government, I suggest buying trust preferreds, which have a debt component, rather than DRD/QDI preferreds. Because of their debt component, trust preferreds are SENIOR to the preferreds being purchased by the government. If you trust the government, feel free to buy non-cumulative preferreds. I would rather stay senior to Uncle Sam, thank you.
By the way, I am not alone with my concerns about the Government intervention. The following is from an article in today's online Wall Street Journal:
"Any expansion would likely prompt calls by U.S. lawmakers to attach more conditions. Members of Congress have begun pushing Treasury to force banks to lend the money they've received, complaining to Mr. Paulson that they're sitting on the cash or using it to fund acquisitions and pay dividends."
Caveat Emptor!
Wednesday, October 29, 2008
One Is The Loneliest Number
Today, the FOMC cut the Fed Funds rate to 1.00% and the discount rate to 1.25%. The intent is to free up the credit markets. Unfortunately, this is an unlikely proposition. The FOMC's decision is akin to lowering the price of water when water is scarce. The problem is not that credit is too expensive, but that there is little available. To be sure, there is much capital available to banks, thanks in large part to an increasingly encroaching government, but banks are hoarding capital to help absorb losses due to writedowns or to acquire smaller, somewhat troubled, institutions.
There is little upside to lending money to bank counterparties of the public unless the borrower in question is of impeccable quality. Banks do not wish to be exposed to extraordinary counterparty risk (in the case of interbank lending) and investor aversion to mortgage-backed or asset-backed securities mean that securitization is difficult if not impossible. If banks cannot securitize mortgages, they soon run out of capital and essentially become income-oriented investors. A bank engaging in such business practices is not long for this world.
What about GSE mortgages? Why haven't GSE-qualified mortgage rates fallen? According to the Wall Street Journal it is because investors are unsure of the governments long-term treatment of GSE agency and mortgage-backed debt. As I have said many times, Mr. Paulson's and Congress's actions have eroded instead of bolstering investor confidence.
Further eroding investor confidence is the increasingly activist sentiments emanating from Congress. Initially, the government said it was taking a passive interest in banks receiving aid. This is evidenced by the non-voting shares being purchased by the government as part of the recapitalization plan. However, all is not what it appears.
Congress and NY State Attorney General Andrew Cuomo are imposing their will on the banks. The government wants to review Wall Street bonuses and severance packages. No vote is necessary. The government is imposing its will. This is the case for any bank which accepted assistance, including those who were forced by the Treasury to participate two weeks ago. This is not your father's America, but it may be your grandfather's (New Deal).
If cutting the Fed Funds and Discount rates will not help increase lending much, if at all, why bother? The answer is two-fold. First, doing so technically makes short-term capital more affordable although, with the Fed Funds rate already trading in the .25% to .50% area, today's ease will have little effect. Mostly, today's ease was done for psychological reasons. If the public believes the Fed is doing everything it can to fix the system, they may be more willing to invest in banks and provide capital. Maybe some potential home buyers re-enter the market feeling confident that we have bottomed. I believe this to be a mistaken belief and besides, fewer potential buyers can qualify for mortgages.
At some point, weaker borrowers will be foreclosed upon and weaker institutions will fail and then, after much pain, the recovery can begin.
Investors should be wary of investing on the log end of the curve. The printing or money / issuing of debt side is beginning to win the tug of war with the flight to quality. The lowering of short-term rates could hasten the rebalancing away from the dollar and could also help put the brakes on falling commodities prices. Stay short to mid-term and stay in high quality investments. High-yield bond defaults are likely to rise from their relatively mild current pace of approximately 5.00%.
There is little upside to lending money to bank counterparties of the public unless the borrower in question is of impeccable quality. Banks do not wish to be exposed to extraordinary counterparty risk (in the case of interbank lending) and investor aversion to mortgage-backed or asset-backed securities mean that securitization is difficult if not impossible. If banks cannot securitize mortgages, they soon run out of capital and essentially become income-oriented investors. A bank engaging in such business practices is not long for this world.
What about GSE mortgages? Why haven't GSE-qualified mortgage rates fallen? According to the Wall Street Journal it is because investors are unsure of the governments long-term treatment of GSE agency and mortgage-backed debt. As I have said many times, Mr. Paulson's and Congress's actions have eroded instead of bolstering investor confidence.
Further eroding investor confidence is the increasingly activist sentiments emanating from Congress. Initially, the government said it was taking a passive interest in banks receiving aid. This is evidenced by the non-voting shares being purchased by the government as part of the recapitalization plan. However, all is not what it appears.
Congress and NY State Attorney General Andrew Cuomo are imposing their will on the banks. The government wants to review Wall Street bonuses and severance packages. No vote is necessary. The government is imposing its will. This is the case for any bank which accepted assistance, including those who were forced by the Treasury to participate two weeks ago. This is not your father's America, but it may be your grandfather's (New Deal).
If cutting the Fed Funds and Discount rates will not help increase lending much, if at all, why bother? The answer is two-fold. First, doing so technically makes short-term capital more affordable although, with the Fed Funds rate already trading in the .25% to .50% area, today's ease will have little effect. Mostly, today's ease was done for psychological reasons. If the public believes the Fed is doing everything it can to fix the system, they may be more willing to invest in banks and provide capital. Maybe some potential home buyers re-enter the market feeling confident that we have bottomed. I believe this to be a mistaken belief and besides, fewer potential buyers can qualify for mortgages.
At some point, weaker borrowers will be foreclosed upon and weaker institutions will fail and then, after much pain, the recovery can begin.
Investors should be wary of investing on the log end of the curve. The printing or money / issuing of debt side is beginning to win the tug of war with the flight to quality. The lowering of short-term rates could hasten the rebalancing away from the dollar and could also help put the brakes on falling commodities prices. Stay short to mid-term and stay in high quality investments. High-yield bond defaults are likely to rise from their relatively mild current pace of approximately 5.00%.
Monday, October 27, 2008
No Laffing Matter
In today's Wall Street Journal, noted economist Arthur Laffer published an editorial entitled "The Age of Prosperity Is Over". Mr. Laffer pulls no punches. He compares President Bush and the current Congress to Herbert Hoover and accuses Fed Chairman Bernanke of "bungling" monetary policy.
The following paragraphs, in my opinion, speak volumes:
"When markets are free, asset values are supposed to go up and down, and competition opens up opportunities for profits and losses. Profits and stock appreciation are not rights, but rewards for insight mixed with a willingness to take risk. People who buy homes and the banks who give them mortgages are no different, in principle, than investors in the stock market, commodity speculators or shop owners. Good decisions should be rewarded and bad decisions should be punished. The market does just that with its profits and losses."
"No one likes to see people lose their homes when housing prices fall and they can't afford to pay their mortgages; nor does any one of us enjoy watching banks go belly-up for making subprime loans without enough equity. But the taxpayers had nothing to do with either side of the mortgage transaction. If the house's value had appreciated, believe you me the overleveraged homeowner and the overly aggressive bank would never have shared their gain with taxpayers. Housing price declines and their consequences are signals to the market to stop building so many houses, pure and simple."
"But here's the rub. Now enter the government and the prospects of a kinder and gentler economy. To alleviate the obvious hardships to both homeowners and banks, the government commits to buy mortgages and inject capital into banks, which on the face of it seems like a very nice thing to do. But unfortunately in this world there is no tooth fairy. And the government doesn't create anything; it just redistributes. Whenever the government bails someone out of trouble, they always put someone into trouble, plus of course a toll for the troll. Every $100 billion in bailout requires at least $130 billion in taxes, where the $30 billion extra is the cost of getting government involved."
As I have said in the (very recent) past, companies, investors and home owners who made poor decisions, must suffer the consequences (of some kind. Until banks are cleansed of bad assets, markets cleansed of weak companies and home prices are permitted to reset to prices which attract buyers, we will remain in a long and painful economic recession.
For political reasons, politicians in both parties are trying to avoid cutting the cancer out the economy out of fear that the operation will be too painful. In reality, not purging the economy of this rotting disease will prove fatal for capitalism in the U.S.
I am not convinced that this bank bailout will right the economy. It will result in larger banks swallowing relatively-healthy smaller institutions in an effort to pad deposits. Be concerned with large banks which cannot make a substantial acquisition and of smaller institutions which attract no buyers.
Many financial advisers have asked why break-evens on short-term TIPs are negative. The reason is the market is pricing in much deflation during the next two years. Whether or not this happens remains to be seen. However, keep in mind that no matter how cheap a TIP looks, if the rate of inflation declines significantly, one could lose money, even when receiving par at maturity is considered.
Investing in TIPs should be viewed similarly to investing in foreign currency bonds. If the inflation index falls, one can receive less than their investment at maturity. This is just like a currency decline on a foreign bond. I would be very cautious when investing in short-term TIPs. In spite of the fact that TIPs are government securities, investors are SPECULATING on the change in the rate of inflation.
The following paragraphs, in my opinion, speak volumes:
"When markets are free, asset values are supposed to go up and down, and competition opens up opportunities for profits and losses. Profits and stock appreciation are not rights, but rewards for insight mixed with a willingness to take risk. People who buy homes and the banks who give them mortgages are no different, in principle, than investors in the stock market, commodity speculators or shop owners. Good decisions should be rewarded and bad decisions should be punished. The market does just that with its profits and losses."
"No one likes to see people lose their homes when housing prices fall and they can't afford to pay their mortgages; nor does any one of us enjoy watching banks go belly-up for making subprime loans without enough equity. But the taxpayers had nothing to do with either side of the mortgage transaction. If the house's value had appreciated, believe you me the overleveraged homeowner and the overly aggressive bank would never have shared their gain with taxpayers. Housing price declines and their consequences are signals to the market to stop building so many houses, pure and simple."
"But here's the rub. Now enter the government and the prospects of a kinder and gentler economy. To alleviate the obvious hardships to both homeowners and banks, the government commits to buy mortgages and inject capital into banks, which on the face of it seems like a very nice thing to do. But unfortunately in this world there is no tooth fairy. And the government doesn't create anything; it just redistributes. Whenever the government bails someone out of trouble, they always put someone into trouble, plus of course a toll for the troll. Every $100 billion in bailout requires at least $130 billion in taxes, where the $30 billion extra is the cost of getting government involved."
As I have said in the (very recent) past, companies, investors and home owners who made poor decisions, must suffer the consequences (of some kind. Until banks are cleansed of bad assets, markets cleansed of weak companies and home prices are permitted to reset to prices which attract buyers, we will remain in a long and painful economic recession.
For political reasons, politicians in both parties are trying to avoid cutting the cancer out the economy out of fear that the operation will be too painful. In reality, not purging the economy of this rotting disease will prove fatal for capitalism in the U.S.
I am not convinced that this bank bailout will right the economy. It will result in larger banks swallowing relatively-healthy smaller institutions in an effort to pad deposits. Be concerned with large banks which cannot make a substantial acquisition and of smaller institutions which attract no buyers.
Many financial advisers have asked why break-evens on short-term TIPs are negative. The reason is the market is pricing in much deflation during the next two years. Whether or not this happens remains to be seen. However, keep in mind that no matter how cheap a TIP looks, if the rate of inflation declines significantly, one could lose money, even when receiving par at maturity is considered.
Investing in TIPs should be viewed similarly to investing in foreign currency bonds. If the inflation index falls, one can receive less than their investment at maturity. This is just like a currency decline on a foreign bond. I would be very cautious when investing in short-term TIPs. In spite of the fact that TIPs are government securities, investors are SPECULATING on the change in the rate of inflation.
Saturday, October 25, 2008
Another One Bites The Dust
Another One Bites The Dust
Anyone who knows me or has read my articles and blog posts knows that I have a contentious relationship with the Wall Street Journal. Their editorial pages can be blatantly right-wing and their articles discussing various investment vehicles and their raison d’etre have been less than accurate. However, an editorial discussing the latest bubble to burst is completely accurate.
The editorial page in October 24, 2008 edition of the Wall Street Journal discusses the bursting of the “other” bubble. That bubble is the oil bubble. As I have been ranting about for approximately nine months, the run up on oil was due to a weak dollar caused by short-term rates, and speculators who used oil as a dollar hedge. Now that the dollar is strengthening (in spite of low rates), oil prices have fallen. Now that being long oil is not a viable speculation strategy, speculators have left the market. Even a decision by OPEC to cut production has had little effect on oil prices. The belief that the price in oil prices was completely due to fundamentals was fostered by pundits who were ill-informed, dishonest or both.
From where was this demand supposed to come? It was supposed to come from developing nations which had allegedly decoupled from the U.S. They allegedly decoupled even though they relied on the U.S. as the primary market for their goods. That is some feat not to be affected by the economy which purchases the majority of one’s goods. It was all bogus. The market was being manipulated by participants looking to foster a self-fulfilling prophecy.
The danger now is that, it appears that the government is trying to re-inflate the bubble, but it doesn’t know how to do it. I am fearful that it will be successful, but judging by recent policies, there is little chance of doing so in the near future. However, it could happen again a few years from now.
The Fed is expected to lower the Fed Funds target rate to 1.00% at next week’s FOMC meeting. I believe this is a desperate attempt to sooth nerves. It will have little economic effect. Why? The problem is that it is too expensive to borrow, but rather that banks are unwilling or (more accurately) unable to lend, at least not like before. Banks are hoarding cash because they know they will have billions more in writedowns. One only need look to Wachovia as evidence. Prior to it being acquired by Wells Fargo, Wachovia had written-down just over $20 billion. After Wachovia had to come clean for the merger, that number of writedowns rose to over $96 billion. That is quite a jump. One must wonder how much the larger players have yet to write-down. It is likely well over $100 billion.
Thus far, the government’s rescue plans have focused on banks not having to take large writedowns. This is like trying to live with cancer instead of removing the malignant growth. The balance sheet malignancies before the banking system can once again be healthy and investors come back to the markets to re-capitalize the banks.
The free market does work. Yesterday, existing home sales unexpectedly rise fueled by buyers purchasing foreclosed properties. This is a good thing. Once the market is permitted to seek its own level, the housing markets will stabilize and the recover can truly begin. If this is all that is needed, why doesn’t government permit this to happen?
There are two reasons, one social and one economic. The social reason is that Americans have been taught that they are entitled to own their own homes. The real estate industry used this belief to convince buyers that it is their right to own, not just a home, but “the” home. There is also a belief in this country that a bank is evil of it forecloses on home. Owning a home is a responsibility, not a right.
The economic reason is that if home foreclosures continue, home prices will continue to decline. Although the market dictates that home prices should decline, the result would be much damage to bank balance sheets and more failures (possibly including larger institutions) would occur. Banks unwisely loaned money to those who could not pay. Some of it was greed, but some of it was mandated by the government. Congress conveniently leaves itself off the list of guilty parties.
Congress is directly to blame for the deepening crisis. By permitting and (in the case of Barney Frank and Chris Dodd) encouraging Treasury Secretary Paulson to wipe out the GSE preferred holders (allegedly to protect taxpayers), the preferred market was killed. This has eliminated banks from raising Tier-1 capital (Tier-1 consists of preferred stock, common stock or deposits) from private investors. Banks have been raising CD rates to attract deposits and investment banks Morgan Stanley and Goldman Sachs have become bank holding companies is desperate attempts to stay afloat. Other banks have purchases their smaller and weaker brethren to gather deposits. It isn’t enough. This is why the government is buying preferred shares of large (and soon to be mid-size banks and insurance companies). If the government had simply backstopped Freddie and Fannie and purged management, without wiping out shareholders, investors and not taxpayers would be recapitalizing banks and the GSEs.
Where do we go from here? We probably go into a major global recession (we are probably already there). Without confidence in the banking system, investors will continue to flock to the safety of U.S treasuries. This will keep long-term rates low and the dollar relatively strong. This will help consumers by keeping food and every prices low. Of course, job losses will also result. Not until investors are willing to recapitalize banks and banks are willing to lend, we will remain in an economic fund or worse.
How is investor confidence to be restored? Banks must come clean as to their writedowns. If a bank will fail as the result, it should be auctioned-off to healthy banks. Home prices can then be permitted to correct. Yes, some home owners will lose their homes, but buyers who can better afford to own these homes will step up. How can banks obtain enough capital which to lend?
PNC’s acquisition of National City can be used as a blueprint. TARP funds can be used to facilitate purchases of weaker banks by stronger banks. That should be the extent of government involvement. Healthier banks, without government ownership, will attract investors. This will permit banks to recapitalize and lend. The government should also reinstate GSE dividends (as stated by former Fed Governor Wayne Angell). The government should admit its mistake and vow never to do so again. Investors would also recapitalize the GSEs, lessening the burden on taxpayers.
There is one problem with all of this. It requires an apolitical approach. Looks like we’re in for nasty weather, I see bad times today.
Anyone who knows me or has read my articles and blog posts knows that I have a contentious relationship with the Wall Street Journal. Their editorial pages can be blatantly right-wing and their articles discussing various investment vehicles and their raison d’etre have been less than accurate. However, an editorial discussing the latest bubble to burst is completely accurate.
The editorial page in October 24, 2008 edition of the Wall Street Journal discusses the bursting of the “other” bubble. That bubble is the oil bubble. As I have been ranting about for approximately nine months, the run up on oil was due to a weak dollar caused by short-term rates, and speculators who used oil as a dollar hedge. Now that the dollar is strengthening (in spite of low rates), oil prices have fallen. Now that being long oil is not a viable speculation strategy, speculators have left the market. Even a decision by OPEC to cut production has had little effect on oil prices. The belief that the price in oil prices was completely due to fundamentals was fostered by pundits who were ill-informed, dishonest or both.
From where was this demand supposed to come? It was supposed to come from developing nations which had allegedly decoupled from the U.S. They allegedly decoupled even though they relied on the U.S. as the primary market for their goods. That is some feat not to be affected by the economy which purchases the majority of one’s goods. It was all bogus. The market was being manipulated by participants looking to foster a self-fulfilling prophecy.
The danger now is that, it appears that the government is trying to re-inflate the bubble, but it doesn’t know how to do it. I am fearful that it will be successful, but judging by recent policies, there is little chance of doing so in the near future. However, it could happen again a few years from now.
The Fed is expected to lower the Fed Funds target rate to 1.00% at next week’s FOMC meeting. I believe this is a desperate attempt to sooth nerves. It will have little economic effect. Why? The problem is that it is too expensive to borrow, but rather that banks are unwilling or (more accurately) unable to lend, at least not like before. Banks are hoarding cash because they know they will have billions more in writedowns. One only need look to Wachovia as evidence. Prior to it being acquired by Wells Fargo, Wachovia had written-down just over $20 billion. After Wachovia had to come clean for the merger, that number of writedowns rose to over $96 billion. That is quite a jump. One must wonder how much the larger players have yet to write-down. It is likely well over $100 billion.
Thus far, the government’s rescue plans have focused on banks not having to take large writedowns. This is like trying to live with cancer instead of removing the malignant growth. The balance sheet malignancies before the banking system can once again be healthy and investors come back to the markets to re-capitalize the banks.
The free market does work. Yesterday, existing home sales unexpectedly rise fueled by buyers purchasing foreclosed properties. This is a good thing. Once the market is permitted to seek its own level, the housing markets will stabilize and the recover can truly begin. If this is all that is needed, why doesn’t government permit this to happen?
There are two reasons, one social and one economic. The social reason is that Americans have been taught that they are entitled to own their own homes. The real estate industry used this belief to convince buyers that it is their right to own, not just a home, but “the” home. There is also a belief in this country that a bank is evil of it forecloses on home. Owning a home is a responsibility, not a right.
The economic reason is that if home foreclosures continue, home prices will continue to decline. Although the market dictates that home prices should decline, the result would be much damage to bank balance sheets and more failures (possibly including larger institutions) would occur. Banks unwisely loaned money to those who could not pay. Some of it was greed, but some of it was mandated by the government. Congress conveniently leaves itself off the list of guilty parties.
Congress is directly to blame for the deepening crisis. By permitting and (in the case of Barney Frank and Chris Dodd) encouraging Treasury Secretary Paulson to wipe out the GSE preferred holders (allegedly to protect taxpayers), the preferred market was killed. This has eliminated banks from raising Tier-1 capital (Tier-1 consists of preferred stock, common stock or deposits) from private investors. Banks have been raising CD rates to attract deposits and investment banks Morgan Stanley and Goldman Sachs have become bank holding companies is desperate attempts to stay afloat. Other banks have purchases their smaller and weaker brethren to gather deposits. It isn’t enough. This is why the government is buying preferred shares of large (and soon to be mid-size banks and insurance companies). If the government had simply backstopped Freddie and Fannie and purged management, without wiping out shareholders, investors and not taxpayers would be recapitalizing banks and the GSEs.
Where do we go from here? We probably go into a major global recession (we are probably already there). Without confidence in the banking system, investors will continue to flock to the safety of U.S treasuries. This will keep long-term rates low and the dollar relatively strong. This will help consumers by keeping food and every prices low. Of course, job losses will also result. Not until investors are willing to recapitalize banks and banks are willing to lend, we will remain in an economic fund or worse.
How is investor confidence to be restored? Banks must come clean as to their writedowns. If a bank will fail as the result, it should be auctioned-off to healthy banks. Home prices can then be permitted to correct. Yes, some home owners will lose their homes, but buyers who can better afford to own these homes will step up. How can banks obtain enough capital which to lend?
PNC’s acquisition of National City can be used as a blueprint. TARP funds can be used to facilitate purchases of weaker banks by stronger banks. That should be the extent of government involvement. Healthier banks, without government ownership, will attract investors. This will permit banks to recapitalize and lend. The government should also reinstate GSE dividends (as stated by former Fed Governor Wayne Angell). The government should admit its mistake and vow never to do so again. Investors would also recapitalize the GSEs, lessening the burden on taxpayers.
There is one problem with all of this. It requires an apolitical approach. Looks like we’re in for nasty weather, I see bad times today.
Thursday, October 23, 2008
Say What You Mean. Mean What You Say
I have long been critical of government interference during this financial crisis. Although some kind of government intervention is necessary (as little as is practical), it seems as though Federal officials cannot go a week without a market roiling gaff.
Today, FHFA (GSE regulator) chief James Lockhart said in a statement that GSE bonds are "explicitly guaranteed" by the government. This sent GSE bonds prices higher. His statement was consistent with various news stories, including one earlier this month in Barrons. I called foul on that story as the GSEs' charters have not been altered to make their debt explicitly guaranteed by the government. Lo and behold, Mr, Lockhart had to retract his statement and admitted that there is no explicit government guarantee of GSE debt. Silence is truly golden.
There is a quandary among fixed income market participants. Being debated is whether long-term rates will remain low due to the flight to safety (which I believe have a way to go yet) or will the new supply of government debt and dollars cause lobg-term rates to rise?
Currently, the flight to safety is winning the tug-of-war versus new treasury supply and the printing of more dollars. As foreign economies follow the U.S. economy into what could be a deep recession, the flight to safety could prevail over increased supply. When the economy stabilizes and signs of recovery materialize, then the results of increased debt issuance should begin to push long-term rates higher. However, for now, safety is the strategy du jour.
Today, FHFA (GSE regulator) chief James Lockhart said in a statement that GSE bonds are "explicitly guaranteed" by the government. This sent GSE bonds prices higher. His statement was consistent with various news stories, including one earlier this month in Barrons. I called foul on that story as the GSEs' charters have not been altered to make their debt explicitly guaranteed by the government. Lo and behold, Mr, Lockhart had to retract his statement and admitted that there is no explicit government guarantee of GSE debt. Silence is truly golden.
There is a quandary among fixed income market participants. Being debated is whether long-term rates will remain low due to the flight to safety (which I believe have a way to go yet) or will the new supply of government debt and dollars cause lobg-term rates to rise?
Currently, the flight to safety is winning the tug-of-war versus new treasury supply and the printing of more dollars. As foreign economies follow the U.S. economy into what could be a deep recession, the flight to safety could prevail over increased supply. When the economy stabilizes and signs of recovery materialize, then the results of increased debt issuance should begin to push long-term rates higher. However, for now, safety is the strategy du jour.
Wednesday, October 22, 2008
Money Get Away
The myth of the so-called "decoupling" continues to be exposed as just that, a myth. Investors, seeking shelter from the strengthening financial storm. Reports of the dollars' demise have been greatly exaggerated. Notice how oil prices have fallen correlative to the dollars' rise. Some credit demand destruction for the fall of oil prices, but demand destruction does not explain the more than halving of the price of oil since its peak of $147.50 per barrel on July 11, 2008.
The reason for falling oil prices are the strengthening dollar and SPECULATION that demand for oil will wane during the coming recessions. I believe that the price of oil will continue to moderate, in spite of OPEC measures to stem its slide (the cartel meets tomorrow). Oil rose too far too fast when fundamentals are considered. Some critics point to the fact that it is not that the dollar is stronger, but foreign currencies which are weakening. I say it does not matter. All currency exchange rates are relative.
Currently, the U.S. economy is perceived to be less weak and better able to weather the financial storm than its foreign counterparts. However, that may not be the case if we continue to move away from free market ideals and toward European-like market socialism. Failure to maintain free market ideals would make the dollar less desirable as a reserve currency.
The reason for falling oil prices are the strengthening dollar and SPECULATION that demand for oil will wane during the coming recessions. I believe that the price of oil will continue to moderate, in spite of OPEC measures to stem its slide (the cartel meets tomorrow). Oil rose too far too fast when fundamentals are considered. Some critics point to the fact that it is not that the dollar is stronger, but foreign currencies which are weakening. I say it does not matter. All currency exchange rates are relative.
Currently, the U.S. economy is perceived to be less weak and better able to weather the financial storm than its foreign counterparts. However, that may not be the case if we continue to move away from free market ideals and toward European-like market socialism. Failure to maintain free market ideals would make the dollar less desirable as a reserve currency.
Tuesday, October 21, 2008
Tell Me What You See
I have had many calls (and have conducted conference calls) regarding what preferreds we like and with which preferreds we have concerns. First off, we like trust preferreds. A line has been drawn by the Treasury with the GSE preferreds. Trust preferreds have a debt component and have been treated as debt. They are actually senior to the bank preferreds purchased by the government. Yes, Paulson said banks will be permitted to pay preferred and equity dividends as long as they pay the government's dividends. I do not trust Paulson. If deemed necessary, the government can force the banks to do nearly anything as per the Treasury' emergency powers.
As for foreign preferreds, they are in the hands of the respective foreign governments and what they require of institutions receiving government support. Governments have been conspicuously silent on the matter. Our feeling is that they will not comment until they have to (when dividends have to be declared).
I have also received renewed interest in investigating collateral performance of their MBS. This is heartening for us. Rather than throwing the baby out with the bath water, advisers and clients are inquiring about the collateral backing their bonds. In most cases, the collateral is fine, in spite of the trading levels. The best MBS were issued prior to mid-2006.
I have been critical of PIMCO's Bill Gross talking his book. However, PIMCO is one of the best bond fund managers on the planet. The Wall Street Journal reports that PIMCO has been selling treasuries and buying GSE MBS. I agree with this strategy. Unlike private label MBS (which are only backed by the collateral), GSE MBS principal is backed by the GSEs. As government backing of GSE bonds is almost explicit, this is where we would look in the MBS market.
Also, this is not Bill Gross talking his book now, but Wall Street Journal reporting regarding what PIMCO has already done. The new supply of treasury securities should begin to push long-term rates higher. We would not be buyers of long-term treasuries. However, I would be a buyer of TIPs. TIPs breakevens are compelling. They should be. After all, deflation may be the norm for the next year. The time to buy tips is when inflation is tame, not after it begins to roar.
As for foreign preferreds, they are in the hands of the respective foreign governments and what they require of institutions receiving government support. Governments have been conspicuously silent on the matter. Our feeling is that they will not comment until they have to (when dividends have to be declared).
I have also received renewed interest in investigating collateral performance of their MBS. This is heartening for us. Rather than throwing the baby out with the bath water, advisers and clients are inquiring about the collateral backing their bonds. In most cases, the collateral is fine, in spite of the trading levels. The best MBS were issued prior to mid-2006.
I have been critical of PIMCO's Bill Gross talking his book. However, PIMCO is one of the best bond fund managers on the planet. The Wall Street Journal reports that PIMCO has been selling treasuries and buying GSE MBS. I agree with this strategy. Unlike private label MBS (which are only backed by the collateral), GSE MBS principal is backed by the GSEs. As government backing of GSE bonds is almost explicit, this is where we would look in the MBS market.
Also, this is not Bill Gross talking his book now, but Wall Street Journal reporting regarding what PIMCO has already done. The new supply of treasury securities should begin to push long-term rates higher. We would not be buyers of long-term treasuries. However, I would be a buyer of TIPs. TIPs breakevens are compelling. They should be. After all, deflation may be the norm for the next year. The time to buy tips is when inflation is tame, not after it begins to roar.
Sunday, October 19, 2008
Had Enough
Any one who knows me can attest that I no fan of George W. Bush. Yes, I did vote for him twice because his opponents were even more clueless than he. However, it is unfair that his economic policies caused the current financial crisis. What did W. do to precipitate this? The only major economic legislation he has put forth was his tax cuts. That did create an economic boom, but it did not cause the mis-packaging of toxic assets into AAA-rated securities. Freddie and Fannie encouraging home ownership for those who cannot afford it, low interest rates and the unintended consequences of market transparency (which pushed Wall Street firms to trade in derivatives with opaque markets (which began during the Clinton years) are the true culprits.
If Mr. Bush can be blamed for anything it is the performance of his Treasury Secretary, Hammerin' Hank Paulson. Hank talks out of both sides of his mouth and, apparently, is clueless on who to save, who to punish and how to go about either. He has done the most damage since the crisis began.
However, the push or home ownership for all has caused this. Lay the problem squarely at the feet of Chris Dodd and Barney Frank.
The Media and Democratic pundits have done a good job of lumping in John McCain with W. ANYONE who has followed the career of John McCain or has the intelligence to read about the candidates instead of listening to sound-bites and looking to see who looks more "presidential" can attest, John McCain is nothing like George Bush.
This is not so say that Mr. McCain instills me with confidence regarding the economy. He does not. However, he is not George Bush. Barak Obama actually frightens me. Class warfare and socialism are failed beliefs. They do not work to run an efficient economy. His suggestion that companies who move jobs offshore be punished with taxes is grandstanding. U.S. corporations pay the highest corporate tax rates in the developed world. How about cutting corporate taxes for companies who move jobs back to the U.S. to solve their cost differential problem. That won't happen because that is anti-socialist.
Unions will not agree to such a policy unless their Democratic handlers tell them it is alright to do so, even though it would bring jobs back to the U.S. Certain Unions, such as government workers, municipal workers and teachers want do see a less robust corporate sector as its for-profit tenets run counter to their ideology and lifestyles. What they do not realize is that, if there is no strong private sector, tax revenue falls (even if tax rates rise) and layoffs of municipal workers government workers and teachers result.
I encourage everyone to read "The Wealth of Nations" by Adam Smith or, at least, discussions on Adam Smith and Capitalism. Karl Marx and Trotsky are not the sages the left claim them to be.
If Mr. Bush can be blamed for anything it is the performance of his Treasury Secretary, Hammerin' Hank Paulson. Hank talks out of both sides of his mouth and, apparently, is clueless on who to save, who to punish and how to go about either. He has done the most damage since the crisis began.
However, the push or home ownership for all has caused this. Lay the problem squarely at the feet of Chris Dodd and Barney Frank.
The Media and Democratic pundits have done a good job of lumping in John McCain with W. ANYONE who has followed the career of John McCain or has the intelligence to read about the candidates instead of listening to sound-bites and looking to see who looks more "presidential" can attest, John McCain is nothing like George Bush.
This is not so say that Mr. McCain instills me with confidence regarding the economy. He does not. However, he is not George Bush. Barak Obama actually frightens me. Class warfare and socialism are failed beliefs. They do not work to run an efficient economy. His suggestion that companies who move jobs offshore be punished with taxes is grandstanding. U.S. corporations pay the highest corporate tax rates in the developed world. How about cutting corporate taxes for companies who move jobs back to the U.S. to solve their cost differential problem. That won't happen because that is anti-socialist.
Unions will not agree to such a policy unless their Democratic handlers tell them it is alright to do so, even though it would bring jobs back to the U.S. Certain Unions, such as government workers, municipal workers and teachers want do see a less robust corporate sector as its for-profit tenets run counter to their ideology and lifestyles. What they do not realize is that, if there is no strong private sector, tax revenue falls (even if tax rates rise) and layoffs of municipal workers government workers and teachers result.
I encourage everyone to read "The Wealth of Nations" by Adam Smith or, at least, discussions on Adam Smith and Capitalism. Karl Marx and Trotsky are not the sages the left claim them to be.
Saturday, October 18, 2008
Fool Me Twice, Shame On Me
My argument against Treasury wiping out GSE preferred holders was that it would destroy investor confidence in the preferred market and any area in which the government intervened. As we have since experienced, this is exactly what has happened. Cheerleaders on the markets' sidelines have been shouting their support of government intervention, but investors have been much less sanguine. Some may argue that having a dog in the fight (I do work on a fixed income desk and own FREprZ) that I am just voicing by bias. However, I am not the only (and definitely not the most influential) critic.
The markets' aversion for anything Paulson-related should be enough proof that the government is sapping, rather than instilling, confidence in financial preferreds and common equity. However, other fixed income experts have voiced opinions similar to my own and those of many fixed income market participants. James Grant, publisher of Grant's Interest Rate Observer, has published an article in the Wall Street Journal. The following paragraphs from the article speak volumes:
"Perhaps the world has gone so far down the path of socialized finance that there's no turning back. However, the doughty remnant of capitalists should be under no illusion about the risks and opportunities they confront. They can't miss the risks. Mr. Paulson pledges that the government's bank investments will be passive and apolitical, but the record of the Depression-era Reconstruction Finance Corp. suggests that the federal government is a shareholder that can throw its weight around. Besides, would Mr. Paulson's apolitical intentions bind his successor?"
Until The government backs away from its ownership interest in the private sector, I will be fearful of a GSE-like outcome.
The markets' aversion for anything Paulson-related should be enough proof that the government is sapping, rather than instilling, confidence in financial preferreds and common equity. However, other fixed income experts have voiced opinions similar to my own and those of many fixed income market participants. James Grant, publisher of Grant's Interest Rate Observer, has published an article in the Wall Street Journal. The following paragraphs from the article speak volumes:
"Perhaps the world has gone so far down the path of socialized finance that there's no turning back. However, the doughty remnant of capitalists should be under no illusion about the risks and opportunities they confront. They can't miss the risks. Mr. Paulson pledges that the government's bank investments will be passive and apolitical, but the record of the Depression-era Reconstruction Finance Corp. suggests that the federal government is a shareholder that can throw its weight around. Besides, would Mr. Paulson's apolitical intentions bind his successor?"
Until The government backs away from its ownership interest in the private sector, I will be fearful of a GSE-like outcome.
Wednesday, October 15, 2008
He Talks To Angell
Former Fed governor Wayne Angell tells CNBC that the government should instill confidence in preferred shares to get investors to recapitalize troubled institutions. He went on to blame the Treasury for blowing up GSE preferreds for starting this panic and believes that the government should reverse its GSE preferred decision and invite investors to recapitalize FRE and FNM.
If li'l ole me could figure out that suspending GSE dividends was a very bad idea and Wayne Angell agrees, why didn't Paulson realize that last month? Because he and Congress are detached from the retail side of the markets.
If li'l ole me could figure out that suspending GSE dividends was a very bad idea and Wayne Angell agrees, why didn't Paulson realize that last month? Because he and Congress are detached from the retail side of the markets.
Power and Responsibility
In the Spiderman story, young Peter Parker is told this by his Uncle Ben. Uncle Ben explained that just because one can do something doesn’t mean they should. This is a lesson the banking industry (and the world) is currently learning.
Beginning with President Reagan’s push for deregulation and free markets and continuing through President Clinton’s signing off on the abolishment of the Glass-Steagall act in 1999, the U.S. economy enjoyed a degree of freedom not seen since before the great depression. Financial institutions took advantage of their newly-found power. However, we now know they fell short in the responsibility department. Thanks to the banks, we have moved from an era of free-market capitalism, to an era of government control and intervention. Goodbye Adam Smith. Hello John Maynard Keynes.
What does this mean for banks, the economy and the markets? First, the days of 20 or 30 times leverage is dead. Since common sense did not prevent this kind of levering, the government will. The government will likely try to head off crises such as we have now by constantly overseeing bank operations. This means earnings will be lower than in the recent past and equity dividends will remain somewhat low for the foreseeable future.
Secondly, the days of easy lending are over as well. Although it is true that banks are now better-capitalized, their abilities to lend hinge on investor appetite for asset-backed, mortgage-related securities. No longer will investors merely trust the credit rating services. They will want to know the specific details of the underlying collateral. Vehicles backed by lower-quality assets will be shunned by many investors, regardless of the level of seniority of the tranche in question.
Lastly, reduced leverage and the resulting reduced lending (albeit better than today’s lending environment) will keep economic growth below levels seen during the housing bubble. It will also prevent the purchasing of big ticket items, such as homes and automobiles, from reaching bubble levels. Big ticket items will now be purchased by those who can truly afford them (for the most part).
This will mean that home prices will rise, but at a pace dictated by the gradual movement of the supply glut of homes. Until home inventories fall (and they are sizeable) home prices will fall and then stagnate. Automakers which are already in precarious situations could find themselves in bankruptcy, unless they are the beneficiaries of government assistance.
Is this the end of the pain for the banks? No, they still have toxic assets on their balance sheets. They will have to take losses, unless the government buys the toxic assets at prices above what they are truly worth. Make no mistake, many (if not most) of the toxic assets on bank balance sheets have essentially failed. While the assets are not worth zero, they are not worth par and never will be. Want a hint of how bad things could be? Wachovia had to come clean as a result of it being purchased by Wells Fargo. According to Bloomberg News, Wachovia has now written down $96.7 billion. This is almost twice what Citi has written down ($54.7B). Citi is believed to have the largest collection of toxic assets. Only government over-payment via TARP or creative accounting can prevent further large writedowns at the major banks.
Preferred holders can breathe a sigh of relief now that it is clear that the government will not require banks to suspend preferred or even common dividends, so long as the banks pay dividends on government owned preferreds. There is one fact of which investors and financial advisers should be aware. Trust preferreds are SENIOR to government preferreds. In theory, banks could not pay the government and still pay the dividends on trust preferreds. Also, since trust preferreds are cumulative, investors are entitled to missed dividends as long as the issuer does not fail. Bank failures have just become much less likely thanks to the Peoples Republic of America
What does this mean for interest rates and corporate bond yields? Long-term interest rates should rise due to the new supply of government debt and the dilution of the value of the dollar. However, that may be moderated some by a continued flight to the dollar as the U.S. is still the safest place to park one’s money.
Corporate bond spreads on non-financials should not change much, narrowing somewhat, as they have not widened out in the same fashion as financials. Financial sector senior notes could experience significant spread narrowing now that the government is temporarily guaranteeing senior bonds. Although rising long-term rates could erode any capital gains benefits from spread narrowing, I believe that the spread narrowing may be enough to keep corporate bond prices stable.
For the next year or two we will be playing defense. Investors should stay with the higher quality names as the near-term economic weakness could be a death-knell for troubled companies.
Beginning with President Reagan’s push for deregulation and free markets and continuing through President Clinton’s signing off on the abolishment of the Glass-Steagall act in 1999, the U.S. economy enjoyed a degree of freedom not seen since before the great depression. Financial institutions took advantage of their newly-found power. However, we now know they fell short in the responsibility department. Thanks to the banks, we have moved from an era of free-market capitalism, to an era of government control and intervention. Goodbye Adam Smith. Hello John Maynard Keynes.
What does this mean for banks, the economy and the markets? First, the days of 20 or 30 times leverage is dead. Since common sense did not prevent this kind of levering, the government will. The government will likely try to head off crises such as we have now by constantly overseeing bank operations. This means earnings will be lower than in the recent past and equity dividends will remain somewhat low for the foreseeable future.
Secondly, the days of easy lending are over as well. Although it is true that banks are now better-capitalized, their abilities to lend hinge on investor appetite for asset-backed, mortgage-related securities. No longer will investors merely trust the credit rating services. They will want to know the specific details of the underlying collateral. Vehicles backed by lower-quality assets will be shunned by many investors, regardless of the level of seniority of the tranche in question.
Lastly, reduced leverage and the resulting reduced lending (albeit better than today’s lending environment) will keep economic growth below levels seen during the housing bubble. It will also prevent the purchasing of big ticket items, such as homes and automobiles, from reaching bubble levels. Big ticket items will now be purchased by those who can truly afford them (for the most part).
This will mean that home prices will rise, but at a pace dictated by the gradual movement of the supply glut of homes. Until home inventories fall (and they are sizeable) home prices will fall and then stagnate. Automakers which are already in precarious situations could find themselves in bankruptcy, unless they are the beneficiaries of government assistance.
Is this the end of the pain for the banks? No, they still have toxic assets on their balance sheets. They will have to take losses, unless the government buys the toxic assets at prices above what they are truly worth. Make no mistake, many (if not most) of the toxic assets on bank balance sheets have essentially failed. While the assets are not worth zero, they are not worth par and never will be. Want a hint of how bad things could be? Wachovia had to come clean as a result of it being purchased by Wells Fargo. According to Bloomberg News, Wachovia has now written down $96.7 billion. This is almost twice what Citi has written down ($54.7B). Citi is believed to have the largest collection of toxic assets. Only government over-payment via TARP or creative accounting can prevent further large writedowns at the major banks.
Preferred holders can breathe a sigh of relief now that it is clear that the government will not require banks to suspend preferred or even common dividends, so long as the banks pay dividends on government owned preferreds. There is one fact of which investors and financial advisers should be aware. Trust preferreds are SENIOR to government preferreds. In theory, banks could not pay the government and still pay the dividends on trust preferreds. Also, since trust preferreds are cumulative, investors are entitled to missed dividends as long as the issuer does not fail. Bank failures have just become much less likely thanks to the Peoples Republic of America
What does this mean for interest rates and corporate bond yields? Long-term interest rates should rise due to the new supply of government debt and the dilution of the value of the dollar. However, that may be moderated some by a continued flight to the dollar as the U.S. is still the safest place to park one’s money.
Corporate bond spreads on non-financials should not change much, narrowing somewhat, as they have not widened out in the same fashion as financials. Financial sector senior notes could experience significant spread narrowing now that the government is temporarily guaranteeing senior bonds. Although rising long-term rates could erode any capital gains benefits from spread narrowing, I believe that the spread narrowing may be enough to keep corporate bond prices stable.
For the next year or two we will be playing defense. Investors should stay with the higher quality names as the near-term economic weakness could be a death-knell for troubled companies.
Monday, October 13, 2008
No Value
No Value
There is an excellent editorial in today’s Wall Street Journal discussing the Value at Risk model and how it failed the markets during the current economic crisis. It is nice to see someone else besides myself criticize the blind reliance on models.
For years I have written of the dangers of the fire and forget method of investing. Value at Risk models are only as good as their input data. One can plug in historical data and a formula (being based on logic) can spit out a result. What a formula can never account for is the human element which is the basis of markets and the economy as a whole. The economy is not like the orbiting of the Space Shuttle or a communications satellite. Engineers can use mathematical formulas to make a satellite remain in a specified orbit. Since there is no human interaction with the direction or speed of the satellite, once in orbit, it will perform as planned by a formula. We can predict the arrival of Halley’s Comet. However, markets and economies are all about human interaction. It is why they exist. The reducing of markets and economies into mathematical formulas will always be problematic because formulas cannot predict the human mind. This is, apparently, surprising to some. It is mainly surprising to the scientists who created the formulas. My advise is to learn the markets and human nature before creating a formula.
Where did the formulas fail us? As the Journal article stated, they did not take into account the politically-motivated decisions regarding Freddie and Fannie and their social lending to people who could not afford a home or the home which they wished to purchase. The so-called Value at Risk models did not (could not) take into account that many mortgages this time around were issued with little or no documentation. Models cannot factor in home flippers who purchased multiple homes with no money down and, because they never paid down payments, have no impetus to try to make mortgage payments. Remember, these were not the roofs over their heads, but investment speculations. Even primary homeowners who put little or no money down have little incentive to pay their mortgages. Buying a home with no money down is similar to renting in that the only capital expended was to make monthly payments. If one cannot afford the monthly payments, one can simply move to a rental property with nothing lost, except for the monthly payment which would have been made anyway be it rent or mortgage payments.
Formulas should be used as guides and re-engineered to account for new market and economic developments. However, this defeats the purpose of formulas. Investment banks and hedge funds use formulas to manage large pools of money most efficiently. Constant human attention makes it less efficient to do so. Some also believe that adding more human interaction creates more volatility and unpredictability. Too bad, the markets are complex and, often, dangerous places. I would rather have a sharp and savvy trader than a reborn physicist creating formulas based on old data and having little if any market experience. This is akin to the age-old criticism of the military. Military strategies are often criticized for planning to fight the last war. History has demonstrated that the strategy which recognizes and reacts to new realities prevails.
There is an excellent editorial in today’s Wall Street Journal discussing the Value at Risk model and how it failed the markets during the current economic crisis. It is nice to see someone else besides myself criticize the blind reliance on models.
For years I have written of the dangers of the fire and forget method of investing. Value at Risk models are only as good as their input data. One can plug in historical data and a formula (being based on logic) can spit out a result. What a formula can never account for is the human element which is the basis of markets and the economy as a whole. The economy is not like the orbiting of the Space Shuttle or a communications satellite. Engineers can use mathematical formulas to make a satellite remain in a specified orbit. Since there is no human interaction with the direction or speed of the satellite, once in orbit, it will perform as planned by a formula. We can predict the arrival of Halley’s Comet. However, markets and economies are all about human interaction. It is why they exist. The reducing of markets and economies into mathematical formulas will always be problematic because formulas cannot predict the human mind. This is, apparently, surprising to some. It is mainly surprising to the scientists who created the formulas. My advise is to learn the markets and human nature before creating a formula.
Where did the formulas fail us? As the Journal article stated, they did not take into account the politically-motivated decisions regarding Freddie and Fannie and their social lending to people who could not afford a home or the home which they wished to purchase. The so-called Value at Risk models did not (could not) take into account that many mortgages this time around were issued with little or no documentation. Models cannot factor in home flippers who purchased multiple homes with no money down and, because they never paid down payments, have no impetus to try to make mortgage payments. Remember, these were not the roofs over their heads, but investment speculations. Even primary homeowners who put little or no money down have little incentive to pay their mortgages. Buying a home with no money down is similar to renting in that the only capital expended was to make monthly payments. If one cannot afford the monthly payments, one can simply move to a rental property with nothing lost, except for the monthly payment which would have been made anyway be it rent or mortgage payments.
Formulas should be used as guides and re-engineered to account for new market and economic developments. However, this defeats the purpose of formulas. Investment banks and hedge funds use formulas to manage large pools of money most efficiently. Constant human attention makes it less efficient to do so. Some also believe that adding more human interaction creates more volatility and unpredictability. Too bad, the markets are complex and, often, dangerous places. I would rather have a sharp and savvy trader than a reborn physicist creating formulas based on old data and having little if any market experience. This is akin to the age-old criticism of the military. Military strategies are often criticized for planning to fight the last war. History has demonstrated that the strategy which recognizes and reacts to new realities prevails.
Saturday, October 11, 2008
Not Short of Mistakes
This week the Dow suffered its biggest one week loss ever and the S&P suffered its worst week since 1933. Some people are lambasting the shorts as the reason for the tanking markets and while we have no love lost for short positions taken by market manipulators, negative opinions are not without some justification, Besides, the short sale suspension came off last Thursday. It was not responsible for the first three days of the sell off. The real problem is our treasury secretary Hank Paulson.
Hank's missteps began with his handling of the GSEs. Short sellers, for a variety of reasons, were beating up share prices of financial institutions and the GSEs. This was making it very costly for them to raise capital in the open market. However, they were still able to do so. Mr. Paulson in an attempt to calm market fears over the GSEs asked for and received almost unlimited power to backstop the GSEs. The market was not convinced this was a good, thing. If Mr. Paulson used his powers and seized the GSEs, preferred holders could be wiped out and that would have locked up the capital markets.
Mr. Paulson dismissed this as an overreaction. However, this is exactly what has happened. Mom and Pop investors and banks (the biggest buyers of preferred - which give much-needed Tier-1 capital) have been scared away. Bond and commercial paper buyers were scared away as Lehman and Wamu were permitted to fail. In fact it is the inconsistency of government actions which has locked up the markets.
Why has poor government decision making locked up the markets? Because, in spite of what the government and CNBC guests tell us, banks and other institutions are LOADED with bad assets. Assests which will NEVER fully recover. Since banks know what toxic assets they have and have a good idea what their counterparties have, interbank lending has basically ceased. The markets want either a cleansing of balance sheets with institutions taking their medicine or a complete government bailout, explicitly guaranteeing banks. Anything else will leave the markets locked and make a deep recession or depression possible.
Hank's missteps began with his handling of the GSEs. Short sellers, for a variety of reasons, were beating up share prices of financial institutions and the GSEs. This was making it very costly for them to raise capital in the open market. However, they were still able to do so. Mr. Paulson in an attempt to calm market fears over the GSEs asked for and received almost unlimited power to backstop the GSEs. The market was not convinced this was a good, thing. If Mr. Paulson used his powers and seized the GSEs, preferred holders could be wiped out and that would have locked up the capital markets.
Mr. Paulson dismissed this as an overreaction. However, this is exactly what has happened. Mom and Pop investors and banks (the biggest buyers of preferred - which give much-needed Tier-1 capital) have been scared away. Bond and commercial paper buyers were scared away as Lehman and Wamu were permitted to fail. In fact it is the inconsistency of government actions which has locked up the markets.
Why has poor government decision making locked up the markets? Because, in spite of what the government and CNBC guests tell us, banks and other institutions are LOADED with bad assets. Assests which will NEVER fully recover. Since banks know what toxic assets they have and have a good idea what their counterparties have, interbank lending has basically ceased. The markets want either a cleansing of balance sheets with institutions taking their medicine or a complete government bailout, explicitly guaranteeing banks. Anything else will leave the markets locked and make a deep recession or depression possible.
Subscribe to:
Posts (Atom)