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.
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