Twisting By The Pool

"Yeah Dancing to The Euro-beat. Yeah Gonna be so cool. Twisting by the- Twisting by the -Twisting by the pool" - Dire Straits.

They are dancing in Europe. Just weeks after criticizing the U.S. for considering a rescue plan, European governments have been forced to bail out venerable firms such as B&B in the UK and Fortis and Dexia in the Netherlands and Belgium. Since other banks, such as the Royal Bank of Scotland and Deutsche Bank also have exposure to toxic assets, more help may be on the way. In fact, this afternoon Bloomberg News reported that German Chancellor Angela Merkel and British Prime Minister Gordon Brown were advocating action to help the Euro financial system. On the news, preferred securities issued by European financial institutions rallied significantly. Further proof that decoupling is a myth.


On another note, I have always been of the opinion that the kind of preferred structure one invests in did not matter much. The reasoning was that companies did not suspend dividends unless they were teetering on bankruptcy, in a bankruptcy preferred holders receive little if any recovery, regardless of class and when companies are taken over all securities are usually either bought by the new owner or it assumes the obligations. Recent developments, beginning (if not caused by) Freddie and Fannie preferreds have made it clear that structures do matter.

Because of this, I suggest that investors looking to invest in the preferred market should consider cumulative trust preferred structures, but not because they are cumulative. It is because of their debt component. As we have seen in recent deals, such as Wachovia, trust preferreds have been treated as very subordinate debt and have been assumed by the acquiring company. Why take chance for 100 basis points?

Can't See The Forest For The Trees

The House of Representatives failed to pass a rescue plan for the financial system. Although I share the same concerns and similar personal beliefs of those who voted no (and their constituents), we are living in extraordinary times. I too would like to see financial institutions, irresponsible mortgage brokers and borrowers and ratings agencies suffer, but the consequences of not passing a deal are too horrible to consider. I shudder to think of how the markets will behave until the House reconvenes on Thursday.

Citi purchased the banking operations, private bank and investment bank of Wachovia. This deal could turn out to be a real coup for Citi (thanks to FDIC backstopping), but Citi is being vague on certain aspects of the deal (branch branding, preferreds, etc.) As usual, C management are hiding under their desks, refusing to comment or state opinions (worthless creatures). Even Citi investor relations has been silent. Same as it ever was at the big C.

Fools On The Hil

The fools on capital hill have tentatively agreed to a rescue plan for troubled financial institutions (and by extension the economy). Taxpayers may also end up winners in the deal, unless you are a taxpayer who make their mortgage payments or invested in Freddie and Fannie preferreds (at par, not a discount) with the encouragement of Ofheo (wh stated repeatedly that the GSEs were healthy). According to the plan, homeowners facing foreclosure will receive a tax holiday. Too bad if you did not purchase too much home or chose financing vehicles wisely.

Banks which invested in GSE preferreds will also received tax benefits to cushion the blow from the Treasury's wiping out (hopefully temporarily) of GSE preferred shares. However, if an individual purchased Freddie and Fannie shares for income (one does not usually speculate via preferred shares), he or she is out of luck.

Once again, responsible citizens who exhibited proper financial restraint and wisdom get hosed by the government. The song remains the same.

Dimons Are Forever

Jamie Dimon executes yet another coup by purchasing Wamu's deposits and branches for $1.9B. J.P. Morgan is buying Wamu's deposits, but nit the company. Therefore, it is not responsible for paying off WM bonds, preferreds or common equity. WM common and preferred shareholders, along with subordinate debt holders, are probably wiped out!. This is yet another blow to the preferred market.

It is all positive for JPM. Yes, JPM will begin to write down $30 billion of bad mortgages, but how far? A government rescue plan could make even this portion of the deal profitable. JPM issued $11 billion of common equity to raise capital. These new shares were scooped up by the market. In spite of the new shares entering the market, JPM share prices rose yesterday as investors climb aboard a gilded JPM band wagon. The deal catapults JPM into the number one position in terms of U.S. deposits ($911B versus $804B for Citi).

JPM does take on exposure to Wamu;s $28 billion risky credit card portfolio, but since JPM has, for the most part, avoided such exposure, the country's largest bank by deposits should be able to deal with this exposure quite handley. I wonder how C employees feel about their boy running JPM in such a competent fashion?

I Wish My Brother George Was Here

President Bush addressed the nation tonight to discuss the rescue of the financial system. Although his address was basically correct (understandably basic), there was a portion which was misleading. I am not sure if this was intentional or was the result of ignorance.

The portion in question was when he stated that most of the borrowers who make up these troubled mortgage-related vehicles will make the effort to pay their loans. Not so George. Many of the troubles mortgage-related CDOs (we won't even discuss the more exotic structures) are made up of loans which are backed by properties so under water and borrowers who are so financially strapped, they have no intention of paying. They just want out of their properties. Many of these loans are backed by vacation or (especially) investment properties. These borrowers want out of the properties, not to be bailed out.

Also, President Bush makes it sound as though the problem is with plain-vanilla mortgage backed securities. Again, this is not the truth. These Collateralized Debt Obligations (CDOs) are made of of the riskiest loans known to man and are sliced and diced into tranches with different levels of seniority and cashflow horizons.

Again, the talking heads on the news (this time Fox) said that the President should explain to the public that it may not actually cost $700 billion as the government would by these assets at 10 cents on the dollar (Tracy Byrnes). The banks would be crushed if the assets were bought at even 40 cents on the dollar. Many of these assets have not been marked that low on balance sheets. Some have not been marked at all. Why is everyone so clueless out there?

Old Man Potter

In the holiday classic, Bedford Falls banker, Mr. Potter, takes advantage of the depression and a run on the bank to add to his empire. Although the storyline (via George Bailey) criticizes his opportunism, Mr. Potter saw value in a troubled but valuable business and made a wise investment. Today, Old Man (Warren Buffet) made what I believe to be a wise choice and invested $5 billion in Goldman Sachs. The investment is via the purchase of perpetual preferred stock. The public will have the opportunity to invest as $2.5 billion worth of this perpetual preferred stock will be made available to the public.

Mr. Buffet had invested in Salomon Brothers, beginning in 1987 (just before the crash) and although the road was rocky for some time. Mr. Buffet reaped the rewards of his investment when he sold his shares to Citi in 2002. Mr. Buffet also owns significant states in Wells Fargo and American Express.

Goldman is considered to be the best manager of risk on the street. The firm was an early player in the mortgage frenzy, but was one the first firms to exit that sector. Therefore, it has avoided the problems which have plagued other firms. However, Goldman has seen its revenues decline and was caught in the global squeeze on the financial sector. However, when other people were panic selling, Mr. Buffet comes in and buys.

The challenge facing Goldman is how to make money without leverage. With astute investors such as Mr. Buffet providing capital and (in theory) Goldman's ability to accept bank deposits, the firm will be able to earn enough revenue to keep the shop profitable. Or maybe its just a stop gap until things settle down. Only Lloyd Blankfein knows for sure.

I'm Looking Through You

Someone asked me today: "Why doesn't the government know what banks are holding on their balance sheets, specifically the Office of the Comptroller of the Currency"?

The answer is: "It does". The Office of the Comptroller of the currency does monitor banks' asset quality. The problem is that some of the distressed assets were, until a short while ago, AAA-rated. Some cannot be accurately gauged. Few of the troubled assets are performing even moderately well. Should there have been better oversight? Absolutely, but I question whether regulators would have understood what they were looking at. Even banks who structured these deals thought these assets were fine. Ratings agency personnel thought otherwise, but that is another story.

Here is the deal. At best, banks won't have to take many more markdowns. Long-tern rates will rise and, although credit spreads will probably narrow during a recovery, they will stay significantly wider than in the past. Also, look for a weaker dollar to keep commodities prices high in spite of slackening demand.

What about Morgan Stanley and Goldman as banks. Ha! I don't see them attracting many depositors. It is very unlikely they could report earnings at levels which investors have become accustomed with 10 times leverage (versus 20 to 30 times as in the past).

Still there are some values in the fixed income market in the financial sector. Buy the highest quality institutions. Do not move out past 10 years. Preferred buyers should be prepared to experience volatility, but CprM in the 12% areas is ridiculous. Heck BACprH in the high 8.00% are is attractive.

Note: I do not think that inflation will go through the moon, nor to I think long-term interest rates will spiral out of control. Slackening demand will temper inflation and, at some point, long-term rates will attract investors and support the dollar. At what level might that be? My guess is that a 5.50%+ 10-year note may be sufficient. Not too bad on a historical perspective.

My bigger fear is that Congress will make this rescue bill a forum for social change and the financial system will approach a collapse. Unless fraud can be proven, homeowners should not be bailed out for buying homes which they could not afford using loans they could not pay back.

Good Day Sunshine

Some market participants are optimistic that the TARP plan to purchase troubled assets from banks will cure the credit crisis. Fair enough, but those who believe that this plan will result in banks marking up positions and writing up values on their balance sheets may be overly optimistic.

Some of these assets will never perform anywhere near as expected. At best, banks may not have to write down asset values further. How this plan affects banks depends on what assets they hold, what assets come 0n balance sheets in the future and at what price they can sell assets to via the TARP plan.

Either way, long-term rates will probably rise as we inflate our way out of this. Inflation will be tempered by slowing growth and consumption. Future lending will be done in a more judicious manner. We had all better be happy slower growth because the days of leverage are over. The economy will have to grow on fundamentals rather than leverage. Banks will be boring entities, but compared to what could have happened, boring is good.

What Have I Done To Deserve Such A Fate?

Investors in Freddie and Fannie preferreds are finally speaking out. Letters in last Friday's Wall Street Journal correctly point out that investors who purchased GSE preferreds were not billionaire speculators, but Mom and Pop, banks and pensions. An article in today's Wall Street Journal reports that some banks are experiencing significant financial pain from their exposure to GSE preferreds. Banks are asking the government that at least some dividends be paid on GSE preferreds.

This exposes the problem with Treasury Secretary Paulson. Mr. Paulson is an extremely intelligent man and is the right person for the job. However, it appears as though he is disconnected from the retail and small investor side of the business. He needs to consider the impact to main street his actions cause as well as the impact to Wall Street. Preferred dividends could be paid without impacting his GSE plan. Suspending the preferred dividends was purely political. Congress agreed, initially. Let's see how it responds to complaints from banks and constituents.

Gotta Get Back In Time

The current monumental changes on Wall Street. although shocking to some, are quite familiar to students of history. Following the stock market crash of 1929 and the bank failures of 1930/31, money center banks became heavily-regulated and the resulting Glass-Steagall act separated deposit taking banks from investment banks. Traditional banks could no longer risk deposits in the financial markets. This system worked (for the most part) for the next 70 years.

The repeal of the Glass-Steagall act in 1999 permitted the combination of money center banks and investment banks. The argument was that traditional banks were at a disadvantage compared to investment banks and that the resulting efficiencies would result in lower borrowing costs and lower fees for consumers. For the most part, this was correct. Although the repeal of Glass-Steagall did not cause the current financial crisis, it did make it more widely felt.

The problem started with low Fed Funds rates. Low short-term borrowing costs and a steep yield curve made it profitable for institutions to borrow short and lend long (the carry trade). The carry trade itself is not a bad thing, but the wide spread between short-term and long-term yields desensitized institutions from risk. There was enough spread to cushion institutions from losses on some loans.

The next step was to find more borrowers. If the carry trade is very lucrative, more loans will equal more profits. But how can one lend money to shaky borrowers without taking on excessive risk? Securitize them and get them of the balance sheet. Now there was a second problem. Speculative investors who would purchase high-risk mortgages are limited in number. Here is where the quants came in.

Rocket scientists (literally) developed used a structure known as a CDO to carve up pools of risky (being kind here) loans into tranches which ranged from very risky to very safe. How can risky assets back a safe security? Structure the safest (super senior) tranches so that they have the first claim on assets and cashflows. As we know now, a large number of this collateral failed and the safe tranches were no such thing. This is how we got here (in VERY simplified terms).

What happens now? The days of 20 or 30 times leverage are over! Banks usually lever 10 times, but even that may be too much for the immediate future. Although this reduces balance sheet risk, it reduces profit potential. Financial institutions will now be the boring entities they had been through much of history. This is not good for shareholders. Banks will generate modest profits (for the most part) in the near future.

Fixed income investors also have to be concerned as there will be less revenue to pay debt. Thus could keep credit spreads wide. Combine this with higher long-term treasury rates resulting from printing money to rescue the financial system. Although long-term rates may rise, upward pressure may be limited by a weakening economy which should crimp consumer demand.

If my synopsis and forecast of the financial system sounds gloomy, that's because it is gloomy. The rescue plan, although necessary in the long run, will not prevent bank losses in the near term. The government's Troubled Asset Relief Program (TARP) will not buy troubled assets at par. In fact it may set prices below where banks have troubled assets marked (assuming they have been marked at all).

Could the government make money by purchasing assets as significant discounts? Sure, but optimists may wish to contain their joy. Optimists note that the underlying loans (and properties) are not worthless and, in many cases, are being valued below historical recovery values. Please, do not make the same mistake the quants made.

This credit dislocation is very different than any which have preceded it. Home prices inflated farther and faster than at anytime in our history. Simultaneously, mortgages were given to borrowers with poorer creditworthiness than every before. This leads me to believe that recovery on these loans will be lower than ever before.


How do we make credit more available? We reign in lending practices and provide more transparency to increase investor confidence. This will not result in a return to the credit boom of a few years ago, nor should it. However, it should result in a healthy credit environment in which those who can pay their debts receive credit.

In Spite of All the Danger

Wall Street was ecstatic with a temporary moratorium on short sales of financial stocks and the announcement that the government will create some kind of bailout fund (RTC redux?) purchase trouble mortgages, loans and related securities (CDOs, MBS, etc.) from banks. Lost in all this euphoria is how the purchase of troubled mortgage-related assets will affect banks.

Market participants need to understand that these glow-in-the-dark structures will not be purchased from the banks at par, nor will they necessarily be purchased from banks at prices which they are marked on bank balance sheets. In the case of structures to esoteric to discover prices it means that securities (known as Level III assets), which have never been marked down, will be sold at fire sale prices. This will probably lead to more poor earnings reports for financial institutions. What this plan will do, in the near-term, is to permit banks to finally rid themselves of these toxic assets.

Even though they may take more significant losses, financial intuitions will benefit from investors who can be confident in the knowledge that there are no more hidden land mines on bank balance sheets. The next debate will be if marking to market versus marking at economic value. Arguments can be made for either method. However, as a former trader, I am biased to marking to market, unless one never plans to sell that assets.

Also up for debate is whether adherence to the Basel II banking agreements, which sets bank capital requirements, is detrimental for U.S. banks by forcing them to raise capital when it is most difficult to do so, during times of distress when share prices are depressed and investors are running for cover. I say the solution is for banks to do a better job in assessing risk and not leveraging irresponsible. Quants may be brilliant people and their models may be accurate in many scenarios, but what every decision maker must remember is that past performance is not an indication of future result and that one's strategy can cause scenarios in the market which have not previously existed.

The government bailout may not be a good thing for long-term interest rates. We have seen today that the reverse flight to safety pushed long-term treasury yields higher. Investors must also remember that all this government bailing will result in the issuance of more government debt. The new supply will push treasury yields higher. The greater deficit could cause the dollar to weaken, also pushing treasury yields higher.

This leaves investors in a pickle. Short-term rates are too low and long-term rates are probably going to trend higher. I would construct a ladder or barbell using CDs or agency discount notes on the short-end and agency notes 7 to 10 years out. There is no reason for extending out further. I would also consider staying in cash for those investors not needing income at this time. Although I am not a market timer, better days are a ways down the road.

I am not yet convinced that financial sector bonds offer value as volatility may be too much for many moderate or conservative investors. The hits to balance sheets and lower profits than what we have been accustomed to at banks due to reduced leverage (not to mention increased levels of debt) could keep bank credit spreads wide and the expected price stability caused by narrowing credit spreads countering rising treasury yields may not materialize as originally thought. Stay far away from preferreds until more details of the government bailout is known, JPM, WFC and BAC exepted.

Karn Evil 9

Welcome back my friends to the show that never ends. After witnessing the shotgun marriage of Bear Stearns and JP Morgan, the Treasury's sloppy handling of the GSE rescue, a Lehman bankruptcy and a Fed seizure of AIG, the locust that are the shorts (hedge funds et al) have descended on Morgan Stanley. In spite of the fact that Morgan Stanley reported good earnings, certain market participants are now pushing another venerable Wall Street investment bank to the brink of oblivion.

Although one can blame the shorts for finishing the job, Wall Street executives and various industry regulators are truly responsible. It was management who permitted their capital markets genius lever up 30 or more times to make bets on various asset backed structures. Where were the controls? Where was the Fed? No one wanted to derail the gravy train. As repulsive as the short-selling vultures may be, they are just feeding in carcasses left by "financial innovators" who hubristically believed they could turn pools of collateral which had little if any chance of paying off. Sure, the short selling uptick and naked short-selling rules are back tomorrow, but the damage is done. As long as financial institutions have this nuclear waste on their balance sheets, the vultures will descend on one financial institution after another.

No firm is immune and the street knows it. Nearly every financial stock, bond or hybrid which has not engaged in a merger (and some which have) traded lower today. Credit default swap spreads blew out today. Morgan Stanley CDS was offered at 1055 basis points today. As I predicted on my desk, Morgan Stanley is talking to Wachovia (itself the subject of doomsday speculation) among others about a merger. Goldman Sachs and Wamu (talking to JPM)) could be the next targets.

Investors holding securities of firms considered "too big to fail" should be warned that they may not be too big to be seized by the Fed. This is not a short-term phenomenon driven only by shorts. This is a major dislocation of the credit markets. Wall Street and the financial sector will look strikingly different when it is all over. The street will be littered with broken dreams. Hopefully business models will not be nearly as broken as they have been during the past few years.

Strange Brew

What a colossal mess on Wall Street. Lehman files for Chapter XI, CDS traders look to find other counterparties for their swaps. Merrill gets bought by Bank of America and AIG gets stubborn and refuses to sell assets or an interest in itself to private equity firm JC Flowers and want $40 billion from the government. Morgan is appointed by the Fed to negotiate a bridge loan to keep AIG afloat until it can sell assets it doesn't want to sell.

Meanwhile, Treasury's action which wiped out GSE preferreds has made it very difficult, if not impossible, for financial institutions to raise capital. Of course Hank Paulson defended his actions today, again. Meanwhile, Bank of America buy Merrill Lynch and is now, in my opinion, the best constructed financial institution in the U.S (if not the world).

The Fed is likely to cut the Fed Funds rate 50 basis points tomorrow. That may only provide limited help as the Fed Funds affective rate and the TED spread (three-month treasuries versus three-month USD LIBOR) indicates that banks cannot or will not lend to other banks.

Regional banks are sweating it out. Hammered by bad commercial loans and the mistreatment of their GSE preferred holdings (not to mention not being able to borrow in the interbank market) will push some to the brink (if not beyond).

Investors should shun the financial sector for now. CDs and agency debt offer the best safe havens in the fixed income markets. If one must buy financial bonds and preferreds, JPM, BAC and WFC are the best.

All this can be blamed on Wall Street firms who tried to combat shrinking revenues caused by market transparency. No longer able to make market with wide bid to offer spreads, firms looked to enhance profits. This resulted in credit default swaps. Wanting to maximize profits in a time of easy financing, banks (and investment banks) loaned money to nearly anyone to fog a mirror. Some where so-called "NINJA" loans. NINJA stands for No Income, No Job or Assets. Quant geniuses claimed to have found away to take a pool of glow-in-the dark assets and make a AAA security from them. The ratings agencies voluntarily told these structurers how to make tranches AAA. Although the had AAA ratings, firms were not stupid enough to hold them on their balance sheets. The placed them in off-balance sheet vehicles such as SIVs (or so they thought). As these SIVs began to blow up (all the assets in them began to fail) the resulting events of default sent them back onto bank and investment bank balance sheets. Billions of dollars of writedowns and corporate failure has been the result.

The worst is not over. There is more to come. Could there be another large bank in trouble? Possibly, but JPM, BAC and WFC look to be the best. Someone please tell us how Mr. Paulson's handling of the GSEs helped the financial system.


Meanwhile, trading, sales and strategy departments at some firms are leaving their advisers and clients high and dry by refusing to comment on today's developments. This is why independent research and strategy has become so popular.

Champagne Super Nova

A Wall Street star has exploded! Venerable investment bank Lehman Brothers has filed for Chapter XI bankruptcy protection after failing to find a deep-pocketed suitor or partner. Some on the street believe that the dissolution of Lehman will be conducted in an orderly fashion around the street. I am not so sure. Look for more pain among banks and investment banks.

Word is that major firms were trading "as normal" with Lehman on Friday. Lehman said in its filing that its broker-dealer operations would continue as usual. Yeah right. I am not sure if Lehman would be permitted to pay for trades once CH XI is filed. There could be a ripple effect of settlement failures around the street. Bondholders will recover a substantial amount. Street was thinking between 70 to 80 cents on the dollar. Preferreds are probably toast. LEH swaps look like crap now.I was telling people Merrill will look for a bank partner for months. No one wanted to listen. I wanted to describe all this on Friday, but was not permitted to publish. Merrill investors have dodged a bullet. Owners of CFC A and B should be doing cartwheels. I do not think that BAC is hurting for money if it is buying Merrill.AIG is in deep trouble. I-Lease and Am. Gen. will be ok, beaten up, but ok. If AIG cannot successfully restructure, it could be worse for the street than Lehman.The Fed is expanding its Term Security Lending Facility. Up until now, the Fed would only take investment grade debt securities as collateral. Now it will take common equity as well! The Fed increased its Primary Dealer Lending Facility by $25 billion to $200 billion. Also, a group of banks and investment banks, including C, have created a $70 billion fund to ensure liquidity for the market. How this will work exactly, I am not sure, but it smells like the MLEC which was suggested last fall to bailout SIVs.The Fed's action has made the Government the primary repo market participant. The government did not to bailout anyone, but what does it think accepting anything short of stereos and jewelry as collateral is? Look for financial stocks to get crushed. We are at the precipice of a major recession. This will separate the wheat from the chaff. Only the strong will survive. Weaklings will either be gobbled up by stronger companies or fail.

He's Not Heavy. He's my (Lehman) Brother

Here we go again folks. Another Wall Street icon is on the brink of collapse. It is the same old story, bets on an inflated real estate market fueled by easy money (accommodative Fed) and alchemists (Ivy League quants) who believed they could turn lead-like structures, consisting of subprime mortgages, risky commercial real estate loans, LBO loans, credit card receivables, auto loans and whatever they could cram into a structure, into gold. Common sense says that a chain is only as strong as its weakest link. These rockets scientists (some quants are actually rocket scientists) thought different. Thus, they created the CDO (collateralized debt obligation). Wall Street firms and banks believed that they could lay off the risk of such structures by using off-balance sheet vehicles such SIVs. Events of default triggers brought these structures careening back onto financial institutions balance sheets. The result has been billions of dollars in writedowns and losses and the near failures if two Wall Street firms (Bear and Lehman) and the conservatorship of GSEs FNMA and FHLMC.

The question now is: Will Lehman survive? My guess is that it will survive as pieces carved up by banks and private equity firms. The next target on the radar screen appears to by Merrill, which kept writing subprime loans right up until the bitter end (buying subprime lenders to generate new loans fro its structures). While a Merrill (or Lehman) bankruptcy is not likely, the horizon is not sunny for neither Wall Street investment bank.

The strategy here is to hold onto Lehman, Morgan Stanley, Merrill and even Goldman bonds, but preferred holders had better beware of how potential "rescue plans" affect this asset class. Mr. Paulson has set a few dangerous precedents with the GSEs.

In my internal use only publication I created at my employer (taken out of publication for being frighteningly accurate) I warned last month that credit spreads would widen in the corporate bond and preferred markets. Thus far this has been the case. Mr. Paulson believed that his takeover of the GSEs would stabilize the financial sector. Instead, he frightened investors away and has made it nearly impossible for financial institutions to raise Tier-One capital in the equity and preferred securities markets.

Show Me The Money

Reader, Charliein asks if the danger of the GSEs stem form their serving two masters (shareholders and the government). Charliein is absolutely correct! The GSEs were created to provided stability during economic disruptions and to encourage and stimulate home ownership. When they were created they did not serve two masters. They were government agencies. However, Congress came up with a great idea. Why burden the Federal budget with debt when we could have the private sector provide the funding and we will regulate them? Brilliant!

The GSEs issued five kinds of securities to raise capital. First are agency bonds. These have always carried the implied backing of the U.S. Government. Therefore, they offered fairly low rates for investors due to their safety. The GSEs MUST the use proceeds of these bonds to purchase mortgages from lending institutions. Proceeds cannot be used to repair damaged balance sheets. That is what subordinate bonds, preferreds and common equity are for.

The GSEs do not hold the majority of mortgages they purchase. They securitize them into Collateralized Mortgage Obligations or CMOs. These are bonds which get their cashflow from the repayment of the underlying mortgages. Although CMOs issued directly by banks are backed ONLY by the underlying mortgages. CMOs issued by the GSEs are backed by both the mortgages and the GSEs. If the underlying mortgages default (and they are over-collateralized), the GSEs will repay investors principal.

The three other securities have no implied backing. They are subordinate notes, preferreds and common equity. Although these securities have no implied government backing, many investors were willing to accept lower yields (or dividends in the cases of common and preferred) generated by these non-senior asset classes. The reasoning was that the government would not let the GSEs fail. No one ever considered "conservatorship" as being an option, including myself.

Now that we know the different kinds of securities issued by the GSEs, let's discuss how the GSEs got into this mess.

Being shareholder owned, GSE management had a legal obligation to maximize shareholder profits. However, as government sponsored enterprises who could borrow at low rates, Congress via regulator the Office of housing enterprise and oversight (Ofheo) has an obligation to oversee the GSEs to make sure they were managing risk properly and using sound business practices. The GSEs' predicament was the doings of both GSE management (common equity shareholders) and more so, Congress. Here is where the conflict lies.

The GSEs made substantial campaign contributions to the very lawmakers regulating them (Congress). As long as their balance sheets looked "OK" Congress left them alone. The GSEs ability to raise large amounts of capital at low rates permitted Congress to use the GSEs for their pet social projects. Have an area of the Country which needs cheap mortgage financing to encourgae home ownership (or for political payback). Freddie and Fannie mortgage standards could be changed for those areas only, to make those loans possible.

Since Congress was essentially being paid off and had free reign to use the GSEs to further its members social agendas, Congress turned a blind eye to some of the speculating GSE management undertook to increase profits. That is how we arrived at this point. The bailout was also politically-charged.

As the mortgage market began to collapse as borrowers went delinquent or defaulted on mortgages, the GSEs needed to raise capital to compensate for losses (note: it was not their core mortgages which blew up the GSEs, but subprime mortgages it wrote - some at the behest of Congress- and the subprime loans in which they invested).

Since the GSEs could not use AAA-rated agency bonds to repair their balance sheets, they had to use one of the other, aforementioned, vehicles. They couldn't issue subordinate debt as the market for it is limited and they needed Tier One Capital and sub debt is Tier Two (explanations of capital buckets and Basel II would require another discussion). The GSEs could have issued equity shares (and they have from time to time), but that would dilute shareholders further and, since teh equity dividend was already reduced to 5 cents per share, many investors would have stayed away in droves. That left preferreds.

Although technically a kind of equity (senior to common), preferred investors have no voting rights and trade (and usually treated as) long-duration, callable, very subordinate debt. Unlike common equity, investors (mostly banks, insurance companies, pension funds and mom & pop) looking for income. Since preferreds are callable at par ($25 or $50 depending on the issue), price appreciation is limited. The dividend is the attractive feature.

Due to mismanagement and poor oversight, Treasury secretary Paulson and his advisers determined that there was nothing left to do but to take over the GSEs (thanks in no small part to the urging foreign central banks who own billions of the senior debt and wanted an almost explicit guarantee).

If Mr. Paulson took over the GSEs, he had to preserve the senior notes (the reason for taking them over as they need to issue more to keep the mortgage market alive). He also had to proctect the subordinate note holders as, being debt, a default of subordinate debt would cause a technical default and a possible involuntary bankruptcy. Still, to appease politicians (mostly those who caused this mess, he had to sacrifice some investors to avoid criticism over bailing out investors at the expense of taxpayers.

The logical choice would have been common equity holders, but since they were down to 5 cents a share, the criticism would have come anyway. Mr. Paulson was adamant that the next senior class of investors, preferred holders, be wiped out along with common holders even though, like bond holders, were investing for income and had no vote or say in the running of the company.

The Government has done a marvelous spin job of saying how the punished Wall Street in favor of Main Street. However, this rings hollow when one considers that preferred holders consist largely of regional and local banks, pension funds and retired individuals. They blew up Main Street! To add insult too injury, the Government is paying itself 10% (higher than any outstanding preferred) on special GSE preferreds which only it can purchase. It would be cheaper for the GSEs to pay existing preferreds, even when lower bond borrowing costs (not much lower when one considers that treasury benchmarks may rise as much as credit spreads will narrow, negating the borrowing advantage).

Another side effect is that retail investors (the main players in the preferred market) will stay away from preferreds issued by banks. Although companies traditionally would not suspend preferred dividends unless facing bankruptcy, a precedent has been set and troubled banks may be more inclined to suspend common and preferred dividends if they are in trouble. Banks need to come with traditional non-cumulative preferreds to pad their Tier One capital ratios. Good luck doing that now. Feedback I have received from brokers is that they will in now way market preferreds to clients given what has happened to GSE preferreds. Now banks and brokerage firms will have difficulty raising necessary Tier One capital. Look for more trouble in the financial sector this Fall.

Although this post was quite lengthy, it is actually an abridged version of the story. Maybe tomorrow I will explain CDOs, CLOs and other exotic structures which helped blow up the economy.

Sad Day In Mudville

Thanks to self-serving large investors and shady accounting by GSE management, the Treasury has taken control over the mortgage agencies. ALL bond holders will be protected, including sub notes. This is as I expected. What I did not expect was the suspension of preferred dividends as it would harm banks, pensions and insurance companies. Preferred shares are not wiped out, they just won't pay dividend for a while.

I am sorry that this has happened to my readers. I really thought that GSE management was being forthright given the gravity of the situation. I also thought that the Treasury and regulators would not punish the preferred holders as they had no vote and could not have, in any way, prevented GSE mismanagement. They should have been treated as subordinate debt holders. This is the danger of investing in a politically-driven sector.

Not what I appear to be

Multiple sources are reporting that the Treasury will take over the GSEs. However, it is also being reported that common shareholders will have the value of there shares diluted, but not wiped out and that preferred holders and ALL bond holders will be protected by the government. Hear that fear-mongers? Preferreds will survive as will ALL bondholders. Although I may have been incorrect in my belief that a takeover was unlikely (Paulson caved to pressure), I was very correct in my belief that preferred holders and bond investors would come out of this intact. Look for GSE preferreds and bonds to rally sharply Monday morning.

P.S. CNBC's Fast Money had a story which stated that shareholders would be wiped out. The story has since been pulled, but broken link remains as evidence.

You Talking To Me?

Bill Gross has decided to extort the U.S. treasury buy threatening not to invest in any more bank offerings unless Paulson acts. I can only assume that he wants the Treasury to nationalize the GSEs and wipe out equity and preferred invest. Mr. Gross has two facts working against him. 1) Mr. Paulson cannot act unilaterally. He needs the permission of the GSEs, which themselves need approval of their regulators, which in turn need Congressional approval. 2) The damage done to banks from wiping out GSE preferred holders could do more damage to banks than anything Mr. Gross could do.

Mr. Gross wants Mr. Paulson to blow up one set of investors to help another class, one to which Mr. Paulson belongs, mortgage backed securities. He is more than a little disingenuous.

Also Mr. Gross is a liar. He states that the recent Wells Fargo hybrid deal was a retail deal because institutions would not buy it. Hello Pinocchio, your nose is growing. The WFC 9.75% fixed-to-floater was an institutional-only deal. It was not offered to retail clients anywhere, period. Don't believe me? Here is what Wells Fargo CFO Howard Atkins had to say to CNBC's Jim Cramer:

It was very much an institutional transaction," he said. "I’m not quite sure it’s being characterized as being something different.”

Atkins said that over 100 institutions took part in the offering, adding that it was "successful" and "well oversubscribed."

How he gets away with this is beyond me. I guess it is because that many investors are rats and he is a pied piper. Investors who admire Mr. Gross may be better off investing in his funds rather than listening to him and acting on their own. By the time Mr. Gross makes public statements he has already made his bets. The pied piper then leads the rats to their demise.

What’s Brown and Sounds Like A Bell?

In a Monty Python sketch, Python player Eric Idle asks the question: “What’s brown and sounds like a bell”? The answer: “Dung!” Although we do not wish to be so crass, we cannot think of a more fitting description on the so-called decoupling of the U.S. economy from those of our trading partners.

Today, the economy is more global than ever. If the economy is global, how in the world can ANY economy decouple, never mind the world’s biggest economy? I admit that the relationship between the U.S. economy may be more symbiotic (rather than the U.S. being overly dominant as in the past), but as in any symbiotic relationship in nature, when one partner becomes ill, the other(s) feel the effects as well. When that one party is considered the “host”, the effects will be felt among those who depend on the host for their survival.

The U.S. economy remains dominant. It is the world’s market place. If China was no longer able to produce goods affordably, it is likely that another country or countries would be eager and able to take its place. However, take away the U.S. economy with its benchmark consumer spending and the gears of the global economy grind more slowly.

This is what we are now experiencing. U.S. consumer spending has slowed and may continue to slow as long as the housing market is dislocated. Most major foreign economies are now experiencing varying degrees of slowing. This has burst the anti-dollar bubble. The dollar has strengthened sharply versus most foreign currencies. This has, in turn, burst the oil bubble. As we have said previously, strengthen the dollar and oil prices will fall. The threat of increased drilling and alternative energy plans has helped to push oil prices lower as well.

Although I believe that oil prices had been too high given current and future demand versus current and future supply (once other sources of oil, which would be come economically viable with oil at elevated levels, were considered), oil may not fall back to pre-bubble levels. Just as those who predicted ever-rising oil prices have been proven incorrect (for now), calling for oil to fall to $60, $70 or $80 may be premature. Remember, bubbles work in both directions. Look for oil to remain range traded at or near current levels until geo-political events dictate otherwise. Also, look for the dollar to remain range traded in the $1.40 to $1.50 ranged, until economic forces dictate otherwise.

Why is fixed income publication discussing the foreign currency exchange markets? Because I also deal in international bonds denominated in foreign currencies. Many retail investors speculate on the value of foreign currencies versus the U.S. dollar by purchasing bonds denominated in foreign currencies. Make no mistake, when one purchases a bond denominated in foreign currencies, one is speculating. This is true even of AAA-rated sovereign debt. Why is one speculating? Although investors will receive timely interest payments and return of their principal at maturity, those payments will be in the particular currencies in which the bonds are denominated. One may get par at maturity, but what it is worth in U.S. dollars may surprise some investors. If the dollar strengthens, one could lose money by investing in foreign-denominated bonds, even when receiving par at maturity.

This has happened to some investors in recent weeks. We and our colleagues have received several calls asking why and how clients lost money on foreign-denominated bonds when they received par at maturity. The answer was that the U.S. dollar has strengthened. Investors must consider currency risk when investing in foreign denominated bonds.


The GSE situation has settled down. The Wall Street Journal's editiorial page has taken to defending Sarah Pailin and her pregnant daughter. I do not believe any defending needs to be done, but at least the Journal has a new bone on which to chew.


I would like to thank my readers for the kind words we have received during the GSE crisis. With all the negativity pervading the Street, our necks were very exposed (we could have looked like twits if the GSEs had been nationalized) and preferred holders wiped out). However, I believed that when all things were considered, even the most ardent GSE critics would come to realize that wiping out certain investor classes could do more harm than good.