To no one's surprise, the FOMC left the Fed Funds rate unchanged. After all, the Fed Funds target rate is essentially zero (in a range between 0.00% and 0.25%). However, its statement indicates more economic trouble may lie ahead. In it's previous statement, the FOMC described credit as being tight. Today it described credit as being "extremely tight". This is not what was hoped four months into the TARP rescue plan.
The FOMC stated that the Fed will continue to buy MBS and agency debt and is "prepared to by longer-term Treasury securities" if such action is warranted. If the Fed does in fact begin buying long-term treasuries, that could help to keep long-term rates in check. However, at some point, possible a year or two from now, the supply of new bonds and renewed investor appetite for higher returns and stronger currencies are likely to push long-term treasury yields higher. This could also push commodities prices higher.
Will credit yields follow long-term treasury yields higher? Possibly, but there could be a crowding out effect. If investors believe they are being adequately compensated (I.E. the are happy) with higher yields on U.S. treasuries, corporations could be crowded out of the debt market. They would either have to raise their yields high enough to attract investors or find other means of funding. With credit spreads among some names and sectors at or near historical wides. some spread tightening is possible, even probable, but it may not entirely offset the rise of interest rates. I am one who believes that investors should underweight the long end of both the yield curve and credit curve at this time.
Bank stocks and bonds received a boost today after the government moved close to creating a so-called "bad bank" to take troubled assets off of bank balanced sheets. It is interesting how the equity markets become giddy without considering how bad assets would leave bank balance sheets.
Just because banks will be able to rid their balance sheets of bad assets does not mean they will not take more losses. It is unlikely (and foolish) for the government to purchase bad assets at inflated levels. That would guarantee losses for taxpayers (the RTC of the early 90s was a money loser). What it would do is eliminate further downside risk for the banks down the road. However, as some banks have not marked down assets to levels at which they can be sold, even to the government. Some banks have placed assets in the so-called Level III Asset bucket. This bucket is for assets which cannot be marked accurately (according to the owning bank) and have not been marked. Although the bad bank would increase transparency, troubled prophecies could be fulfilled as troubled banks will merely realize losses and end up being seized, nationalized or broken up. Remember, even the RTC permitted troubled S&Ls to fail. Positives came from the RTC's ability to calm fears that healthy banks may be holding on to troubled loans. The weaker banks may not come out of this unscathed.
I have previously mentioned that depressed prices of troubled assets is not just a mark-to-market phenomenon. As homes are foreclosed upon and auctioned off, these previously unrealized losses become realized. There was an article today on Bloomberg which discussed foreclosed properties selling for about 50 cents on the dollar at auction. Of course a spokesman for a consumer advocacy group derided these actions for lowering home values and making things more difficult for homeowners looking to refinance. It is high time that the public, advocates and government officials learn that a commodity or asset is only worth what someone is willing to pay for it. It is quite possible that one's $350,000 home is only worth $175,000.
The purpose of this piece is not to cast a pall over government efforts. I actually believe that a bad bank, RTC-like arrangement will keep most financial institutions intact and prevent nationalization of the banks. I do not believe that it will make all banks instantly healthy. There are some institutions which are sufficiently troubled that they may need more drastic intervention.
This brings us back preferreds (again). I do not believe that preferred dividends will be suspended,even preferred equity dividends of large, but troubled banks. However, it is not an impossibility. Why reach for 17% yield which could be wiped out by the government (for political as well as economic reasons), when one can earn 12% to 14% and be ahead of the government? What about non-cumulative preferreds trading at over 20%? These must be considered speculative investments at this time.
Those looking for a good explanation of trust preferreds should go here:
http://www.leggmason.com/privateclient/pdf/frcs.pdf
Wednesday, January 28, 2009
Tuesday, January 27, 2009
Standing In The Shadows
Standing In The Shadows
Much has been made of the failure of the so-called Shadow Banking System. The question we are most asked regarding this topic is: What is the Shadow Banking System?
The Shadow Banking system consists of non-traditional financial entities which perform the lending functions of a bank. Some components of the Shadow Banking System are investment banks, SIVs, Hedge Funds, etc. These participants either provide financing by borrowing short-term and lending long-term or provide the necessary functions for other members to do so.
On the positive side, without the Shadow Banking System enabled more people to purchase homes and permitted the economy to grow as never before. On the negative side it resulted in lax lending standards, the abuse of credit and opaque risk and collateral exposure to investors. Some pundits the apparent demise of the Shadow Banking System. These pundits should be careful of what they wish for.
The problem does not lie with the idea of an alternative source of funding, but the abuses therein. Instead of the original intent of making borrowing easier and more affordable for qualified borrowers, the Shadow Banking System made it easy for non-deserving, unqualified borrowers obtain credit. The result of less-than-qualified borrowers obtaining mortgages is a record amount of delinquencies, defaults and foreclosures. The problem is moving from a market-to-market, unrealized loss problem, to a realized loss problem as banks either seize homes and sell them for what they can or make deals with homeowners to take whatever the home sells for and call it even with the borrower.
To what extent has the problem infected bank balance sheets? Even now, no one (except, maybe, for the banks themselves) is sure. The combination of the known problems in the housing market and the cloudy picture of bank balance sheets are frightening investors. Until investors are sufficiently confident to purchase uninsured corporate debt and private label (so-called jumbo) mortgage backed securities, which are only backed by the mortgage collateral and not whatsoever by the issuing bank, the housing market will be mired in its current morass.
The government has put itself on the hook for bank survival. Not only has it agreed to explicitly guarantee corporate TLGP bonds, but it has also purchased a preferred equity interest in the banks. The two actions are related. Because of Basel II banking requirements, the banks needed to raise Tier-I capital. Banks could not issued more debt (Tier-II capital) until Tier-I ratios were improved. This is why the government came in at the preferred equity level.
Investors should not consider a government investment at the preferred equity a vote of confidence, but an action of necessity. Advisers and clients should note that although the government’s preferreds are ranked equally with non-cumulative perpetual preferred equity, the so-called TARP preferreds are cumulative. The government gave itself some protection should it become necessary to have a bank (or banks) suspend dividends. If the government had a choice, it would have invested on the most senior place on bank capital structures, the senior secured debt level. However, that would have provided banks with Tie-II capital and not the much-needed Tier-I capital
Why would the government order a bank to suspend dividends? How about to fund operations and pay its debts? After all, a bank can suspend dividends and continue to function. However, if a bank cannot make its coupon payments or mature its debt and it is out of business and not a problem for the government. The problem is two-fold. First: the troubled bank becomes a problem for the FDIC. If that bank happens to be a large money center bank, the FDIC could be stressed to the point of fund depletion. Also, the government would now be responsible for the FDIC-backed TLGP bonds. The government would likely do anything it could not to get to this point.
Some pundits have suggested that investors buy what the government is buying. In other words, invest in the banks the government is backing. I agree with that when it comes to bonds (for reasons I have already mentioned), but not with preferreds. Since the government bought bank preferreds because it needed to do so to boost Tier-I capital ratios and not because it believed doing so was a wise investment and could and would suspend dividends if necessary, preferred investors should get above the government and purchase trust preferreds which, being junior subordinate debt, have a better chance of paying and are cumulative.
Advisers and investors should avoid swinging for the fences and play small ball. A single is better than a strike out.
Much has been made of the failure of the so-called Shadow Banking System. The question we are most asked regarding this topic is: What is the Shadow Banking System?
The Shadow Banking system consists of non-traditional financial entities which perform the lending functions of a bank. Some components of the Shadow Banking System are investment banks, SIVs, Hedge Funds, etc. These participants either provide financing by borrowing short-term and lending long-term or provide the necessary functions for other members to do so.
On the positive side, without the Shadow Banking System enabled more people to purchase homes and permitted the economy to grow as never before. On the negative side it resulted in lax lending standards, the abuse of credit and opaque risk and collateral exposure to investors. Some pundits the apparent demise of the Shadow Banking System. These pundits should be careful of what they wish for.
The problem does not lie with the idea of an alternative source of funding, but the abuses therein. Instead of the original intent of making borrowing easier and more affordable for qualified borrowers, the Shadow Banking System made it easy for non-deserving, unqualified borrowers obtain credit. The result of less-than-qualified borrowers obtaining mortgages is a record amount of delinquencies, defaults and foreclosures. The problem is moving from a market-to-market, unrealized loss problem, to a realized loss problem as banks either seize homes and sell them for what they can or make deals with homeowners to take whatever the home sells for and call it even with the borrower.
To what extent has the problem infected bank balance sheets? Even now, no one (except, maybe, for the banks themselves) is sure. The combination of the known problems in the housing market and the cloudy picture of bank balance sheets are frightening investors. Until investors are sufficiently confident to purchase uninsured corporate debt and private label (so-called jumbo) mortgage backed securities, which are only backed by the mortgage collateral and not whatsoever by the issuing bank, the housing market will be mired in its current morass.
The government has put itself on the hook for bank survival. Not only has it agreed to explicitly guarantee corporate TLGP bonds, but it has also purchased a preferred equity interest in the banks. The two actions are related. Because of Basel II banking requirements, the banks needed to raise Tier-I capital. Banks could not issued more debt (Tier-II capital) until Tier-I ratios were improved. This is why the government came in at the preferred equity level.
Investors should not consider a government investment at the preferred equity a vote of confidence, but an action of necessity. Advisers and clients should note that although the government’s preferreds are ranked equally with non-cumulative perpetual preferred equity, the so-called TARP preferreds are cumulative. The government gave itself some protection should it become necessary to have a bank (or banks) suspend dividends. If the government had a choice, it would have invested on the most senior place on bank capital structures, the senior secured debt level. However, that would have provided banks with Tie-II capital and not the much-needed Tier-I capital
Why would the government order a bank to suspend dividends? How about to fund operations and pay its debts? After all, a bank can suspend dividends and continue to function. However, if a bank cannot make its coupon payments or mature its debt and it is out of business and not a problem for the government. The problem is two-fold. First: the troubled bank becomes a problem for the FDIC. If that bank happens to be a large money center bank, the FDIC could be stressed to the point of fund depletion. Also, the government would now be responsible for the FDIC-backed TLGP bonds. The government would likely do anything it could not to get to this point.
Some pundits have suggested that investors buy what the government is buying. In other words, invest in the banks the government is backing. I agree with that when it comes to bonds (for reasons I have already mentioned), but not with preferreds. Since the government bought bank preferreds because it needed to do so to boost Tier-I capital ratios and not because it believed doing so was a wise investment and could and would suspend dividends if necessary, preferred investors should get above the government and purchase trust preferreds which, being junior subordinate debt, have a better chance of paying and are cumulative.
Advisers and investors should avoid swinging for the fences and play small ball. A single is better than a strike out.
Thursday, January 22, 2009
Good Times, Bad Times
In today's Wall Street Journal David Roche, president of Independent Strategy discusses how to deal with the banks toxic assets. He advocates setting up a bad bank to take on banks toxic assets. He describes what he calls a good-bad bank and a bad-bad bank. A good-bad bank would buy toxic assets at their market prices thereby punishing banks for their bad decisions, but instilling confidence among the public by creating transparency. No longer will investors and depositors worry about what lurks on balance sheets. Those weaker banks can either be recapitalized, nationalized or sold to other banks. A bad-bad bank would essentially absolve banks from their poor decision making and suspect risk management. However, either would permit the economy, asset prices and real estate prices to find a bottom. A bottom that politicians are trying to avoid, but which is necessary. As Mr. Roche states:
"As we saw in Japan in the 1990s, if the market is not allowed to clear, the financial crisis will be prolonged. Although debt deflation may be avoided, the economic recession will be longer and the recovery weaker."
This is something I have said, ad nauseum, for over a year. Politicians have chosen to ease borrowing costs to try and reignite the economy by re-leveraging. Mr. Roche is correct when he says that this could lead to more and larger bubbles. At some point, one must pay the piper.
Although banks may have to pay the piper, troubled banks may not pay dividends. The paying of dividends is how a company shares profit or revenues with its investors. This is as opposed to interest payments which must be made, whether or not a company is profitable. Although I do not believe that preferred stock dividends will be cut (unless in an extreme situation) for political reasons, I would rather own an interest-paying vehicle such as a trust preferred or, even better, a bond rather than a dividend-paying preferred stock which could have its dividend wiped out by either a lack of profits or revenues or for political reasons (the government forcing the issue due to a bank using TARP money to pay dividends).
"As we saw in Japan in the 1990s, if the market is not allowed to clear, the financial crisis will be prolonged. Although debt deflation may be avoided, the economic recession will be longer and the recovery weaker."
This is something I have said, ad nauseum, for over a year. Politicians have chosen to ease borrowing costs to try and reignite the economy by re-leveraging. Mr. Roche is correct when he says that this could lead to more and larger bubbles. At some point, one must pay the piper.
Although banks may have to pay the piper, troubled banks may not pay dividends. The paying of dividends is how a company shares profit or revenues with its investors. This is as opposed to interest payments which must be made, whether or not a company is profitable. Although I do not believe that preferred stock dividends will be cut (unless in an extreme situation) for political reasons, I would rather own an interest-paying vehicle such as a trust preferred or, even better, a bond rather than a dividend-paying preferred stock which could have its dividend wiped out by either a lack of profits or revenues or for political reasons (the government forcing the issue due to a bank using TARP money to pay dividends).
Tuesday, January 20, 2009
That's Amore
So Chrysler is selling a stake in itself to FIAT in an attempt to market attractive small cars? The former domestic small car leader is now going to rely on a company who could not successfully sell its cars in the U.S. to save it from impending doom.
Those who are not familiar with the auto sector may have trouble believing that Chrysler was a leader in anything, but lets get a few facts straight. The last domestic small car to turn a profit was the first generation Dodge / Plymouth Neon. Also, Chrysler was a pioneer of high output, but affordable small engines (the 1985 Dodge Omni GLHS ran 0-60 in about six seconds). A derivative of the original Neon engine powered BMW's Mini.
How did we get here? Following the launch of the Neon and Intrepid in the mid-1990s, Chrysler was the most efficient domestic auto manufacturer and was profitable. However, instead of putting that money back into the company to develop new models. Chrysler spent lavishly on bonuses and higher union compensation. By 1998, Chrysler needed a partner.
Daimler was a disaster for Chrysler. Daimler tried to take Chrysler upscale and stopped nearly all development of small cars. The only small Chrysler being made is the Dodge Caliber / Jeep Compass. This is a heavy, small pseudo-SUV. Oh how the mighty have fallen. FIAT could not make its former venture with GM work and I have doubts about its partnership with Chrysler.
Those who are not familiar with the auto sector may have trouble believing that Chrysler was a leader in anything, but lets get a few facts straight. The last domestic small car to turn a profit was the first generation Dodge / Plymouth Neon. Also, Chrysler was a pioneer of high output, but affordable small engines (the 1985 Dodge Omni GLHS ran 0-60 in about six seconds). A derivative of the original Neon engine powered BMW's Mini.
How did we get here? Following the launch of the Neon and Intrepid in the mid-1990s, Chrysler was the most efficient domestic auto manufacturer and was profitable. However, instead of putting that money back into the company to develop new models. Chrysler spent lavishly on bonuses and higher union compensation. By 1998, Chrysler needed a partner.
Daimler was a disaster for Chrysler. Daimler tried to take Chrysler upscale and stopped nearly all development of small cars. The only small Chrysler being made is the Dodge Caliber / Jeep Compass. This is a heavy, small pseudo-SUV. Oh how the mighty have fallen. FIAT could not make its former venture with GM work and I have doubts about its partnership with Chrysler.
Monday, January 19, 2009
Just A Song Before I Go
Today being a holiday, I will make things short and sweet. First: Bank of America is receiving much criticism for first not doing its due diligence when agreeing to acquire troubled investment bank Merrill Lynch in September and then for asking for government capital last week because or higher than expected losses at Merrill. Although I was uneasy of BAC acquiring MER without TARP funds (MER and another large troubled institutions have the most toxic assets in terms of both quantity and toxicity), I was hopeful that BAC CEO Ken Lewis could pull it off.
According to the Wall Street Journal, Mr. Lewis was considering backing out of the deal to acquire Merrill in December only to be pressured into closing the deal by Treasury Secretary Paulson and Fed Chairman Bernanke. This could be a first in the history of U.S. business. A major corporation was forced to close a deal after determining that it is no longer a sound business decisions.
Questions regarding BAC's poor due diligence may be fair, but are reasons that mergers and acquisitions often close months after they are agreed upon. One reason is that it takes that long for the legal aspects to be addressed. Another are the logistics of efficiently integrating two firms (some firms never addressed this). Yet another is complete information discovery. During BAC's closer at MER's books and businesses, BAC apparently became concerned. Concerned enough to want out. After being subject to a shotgun wedding, forced by the government who can blame Ken Lewis for asking for TARP money. Whether or not BAC was trying to prevent a systemic collapse when it agreed to acquire Merrill on that tumultuous weekend in September which also saw the Lehman bankruptcy and the government's seizure of AIG, but that is exactly what it did. Since the vast majority of mortgage-related losses at BAC come from Merrill Lynch (dwarfing even Countrywide's losses), BAC is likely to get any assistance needed from the government. After all, another large bank received similar additional aid after causing its own crisis.
Another bank having trouble is the Royal Bank of Scotland. The Wall Street Journal is reporting that RBS has announced that it will suffer a "huge" loss for 2008, possibly more than $41 billion. Word out of London is that RBS will probably need more government capital. Some estimates put the eventual government ownership of RBS at 70%, up from the current level of 58%.
Thus far, the British government has not forced RBS to eliminate its preferred dividends. That however, may not be the case going forward. As RBS preferreds are non-cumulative, investors relying on RBS preferreds for income may wish to swap into investments more in line with their risk tolerance and investment objectives.
According to the Wall Street Journal, Mr. Lewis was considering backing out of the deal to acquire Merrill in December only to be pressured into closing the deal by Treasury Secretary Paulson and Fed Chairman Bernanke. This could be a first in the history of U.S. business. A major corporation was forced to close a deal after determining that it is no longer a sound business decisions.
Questions regarding BAC's poor due diligence may be fair, but are reasons that mergers and acquisitions often close months after they are agreed upon. One reason is that it takes that long for the legal aspects to be addressed. Another are the logistics of efficiently integrating two firms (some firms never addressed this). Yet another is complete information discovery. During BAC's closer at MER's books and businesses, BAC apparently became concerned. Concerned enough to want out. After being subject to a shotgun wedding, forced by the government who can blame Ken Lewis for asking for TARP money. Whether or not BAC was trying to prevent a systemic collapse when it agreed to acquire Merrill on that tumultuous weekend in September which also saw the Lehman bankruptcy and the government's seizure of AIG, but that is exactly what it did. Since the vast majority of mortgage-related losses at BAC come from Merrill Lynch (dwarfing even Countrywide's losses), BAC is likely to get any assistance needed from the government. After all, another large bank received similar additional aid after causing its own crisis.
Another bank having trouble is the Royal Bank of Scotland. The Wall Street Journal is reporting that RBS has announced that it will suffer a "huge" loss for 2008, possibly more than $41 billion. Word out of London is that RBS will probably need more government capital. Some estimates put the eventual government ownership of RBS at 70%, up from the current level of 58%.
Thus far, the British government has not forced RBS to eliminate its preferred dividends. That however, may not be the case going forward. As RBS preferreds are non-cumulative, investors relying on RBS preferreds for income may wish to swap into investments more in line with their risk tolerance and investment objectives.
Wednesday, January 14, 2009
Brother Can You Spare A Dime?
Many people were shocked when Bank of America agreed to buy Merrill Lynch with no financial assistance from the U.S. government. My take on this is that BAC could go back to the government for funds at any time. After all, BAC prevented Merrill and Countrywide from collapsing. A collapse of either firm would have had dire systemic consequences. Today it was announced that BAC will indeed receive money from the government to help close the Merrill deal. BAC will receive an as yet unannounced sum (measured in $billions) from the government. Merrill is being crushed under the weight of very toxic assets. I as have written previously, Merrill (and another large institution which is being broken up by order of the Fed and The Office of the Comptroller or the Currency) were not only the largest structurers and dealers of toxic asset-backed securities, but in fact, ramped up the securitization at the height of the real estate bubble in 2006 and into 2007 after most major players had long left that arena.
Could it be that BAC CEO Ken Lewis bit off more than he can chew? Possibly, one financial supermarket is being broken up, could his be next? This would be difficult. Unlike C and MS, his troubled assets lie within the part of the firm which also contains its Global Wealth Management unit. Look for a possible restructuring within BAC. Why doesn't the government just buy these toxic assets? Due to the fact that the collateral contained within many of these vehicles, there is no way that TARP could purchase assets at prices which would be helpful to banks.
Many investors continue to buy non-cumulative preferreds of the "good" banks. Although most, if not all, probably continue to pay the chance of dividend suspensions is not zero. My opinion is that the more government help an institution needs the more likely a dividend suspension. I continue to prefer (pun intended) trust preferred due to their seniority to government preferreds via their debt components. Higher yields offered by non-cumulative preferreds are not sufficient (in my opinion) to justify the risk. After all, the yield contingent on the dividend being paid. Today I had investors tell me that I was overreacting for suggesting BAC trust preferreds over the non-cumulative preferred stocks. The news of BAC's request for more aid after the close legitimizes my concerns.
Could it be that BAC CEO Ken Lewis bit off more than he can chew? Possibly, one financial supermarket is being broken up, could his be next? This would be difficult. Unlike C and MS, his troubled assets lie within the part of the firm which also contains its Global Wealth Management unit. Look for a possible restructuring within BAC. Why doesn't the government just buy these toxic assets? Due to the fact that the collateral contained within many of these vehicles, there is no way that TARP could purchase assets at prices which would be helpful to banks.
Many investors continue to buy non-cumulative preferreds of the "good" banks. Although most, if not all, probably continue to pay the chance of dividend suspensions is not zero. My opinion is that the more government help an institution needs the more likely a dividend suspension. I continue to prefer (pun intended) trust preferred due to their seniority to government preferreds via their debt components. Higher yields offered by non-cumulative preferreds are not sufficient (in my opinion) to justify the risk. After all, the yield contingent on the dividend being paid. Today I had investors tell me that I was overreacting for suggesting BAC trust preferreds over the non-cumulative preferred stocks. The news of BAC's request for more aid after the close legitimizes my concerns.
Monday, January 12, 2009
Over There
Many historians believe that World War II began the day World War I ended. By this it is meant that the terms of Germany's surrender sewed the seeds of the next European war. The same may be said regarding this recession. This recession may begun when the last ended.
The parallel is there. To get a stubbornly moribund economy moving again, the Fed kept the Fed funds rate at 1.00% for a year (June, 2003 to June, 2004) and then raised it very gradually. This fueled the housing boom. An extended period of easy money and low bond yields led to much borrowing and reaching for yield. Investors, strategists and ratings agencies began justifying ever risky credits as being acceptable risks. Consumers believed the low rates were here to stay. This is much like the tech bubble's "New Economy" where old rules no longer applied. Much as then, investors, strategists and ratings agencies were incorrect.
Some historians now consider World War I and Word War II to be essentially the same war with a 21-year lull. It may be that the recession of the early 90s is the same as today's interrupted by the excess of the Tech Bubble (like the Roaring Twenties) and the Fed-fueled real estate bubble. The question now becomes: What will a "normal" economy look like.
This is a good and frightening question. Many businesses, such as Home Builders, Auto Makers, Retailers and investment banks are presently constructed to exist in an economy where credit flows like water. What happens to home builders if buyers actually have to prove they can pay mortgages and investors only buy MBS backed by these mortgages and then only with GSE backing? What happens to the auto makers when buyers choose less expensive vehicles because their payments are higher now that their credit history and ability to pay is being scrutinized (along with the fact that there is no home equity to be used to purchase a vehicle)? Gone are the days when one saved enough money to buy a car for cash. Relatively few Americans can amass $30,000 in a reasonable amount of time to buy a car for cash.
Many people long for the simpler time of the 1950s. A world of Ward and June Cleaver, frugal spending and conservative investments and business models. Except for pipes, slippers and a Bel-Air wagon in the driveway, they may be here. The economy will stabilize, but save for a new technological breakthrough, growth will return to a more modest and steady pace. This will make high-quality bonds, blue chip stocks with high-dividends and bank products the preferred investment vehicles.
Bill Gross has been in the news touting TIPS. He is correct. Although the best opportunities have passed, The 1.375% due 7/15/18 TIP is cheap at about a 1.65% yield a an inflation index below 1.00. This means that if one purchases this TIP and it is held to maturity, one will experience a principal gain due to the fact that a TIP's inflation index cannot be below 1.0 at maturity. If we have positive inflation, this is a relative home run. Inflation needs only to average about 1.0% to equal the return one could earn on the 10-year treasury. This is an attractive break-even.
The parallel is there. To get a stubbornly moribund economy moving again, the Fed kept the Fed funds rate at 1.00% for a year (June, 2003 to June, 2004) and then raised it very gradually. This fueled the housing boom. An extended period of easy money and low bond yields led to much borrowing and reaching for yield. Investors, strategists and ratings agencies began justifying ever risky credits as being acceptable risks. Consumers believed the low rates were here to stay. This is much like the tech bubble's "New Economy" where old rules no longer applied. Much as then, investors, strategists and ratings agencies were incorrect.
Some historians now consider World War I and Word War II to be essentially the same war with a 21-year lull. It may be that the recession of the early 90s is the same as today's interrupted by the excess of the Tech Bubble (like the Roaring Twenties) and the Fed-fueled real estate bubble. The question now becomes: What will a "normal" economy look like.
This is a good and frightening question. Many businesses, such as Home Builders, Auto Makers, Retailers and investment banks are presently constructed to exist in an economy where credit flows like water. What happens to home builders if buyers actually have to prove they can pay mortgages and investors only buy MBS backed by these mortgages and then only with GSE backing? What happens to the auto makers when buyers choose less expensive vehicles because their payments are higher now that their credit history and ability to pay is being scrutinized (along with the fact that there is no home equity to be used to purchase a vehicle)? Gone are the days when one saved enough money to buy a car for cash. Relatively few Americans can amass $30,000 in a reasonable amount of time to buy a car for cash.
Many people long for the simpler time of the 1950s. A world of Ward and June Cleaver, frugal spending and conservative investments and business models. Except for pipes, slippers and a Bel-Air wagon in the driveway, they may be here. The economy will stabilize, but save for a new technological breakthrough, growth will return to a more modest and steady pace. This will make high-quality bonds, blue chip stocks with high-dividends and bank products the preferred investment vehicles.
Bill Gross has been in the news touting TIPS. He is correct. Although the best opportunities have passed, The 1.375% due 7/15/18 TIP is cheap at about a 1.65% yield a an inflation index below 1.00. This means that if one purchases this TIP and it is held to maturity, one will experience a principal gain due to the fact that a TIP's inflation index cannot be below 1.0 at maturity. If we have positive inflation, this is a relative home run. Inflation needs only to average about 1.0% to equal the return one could earn on the 10-year treasury. This is an attractive break-even.
Friday, January 9, 2009
I Need A Fix 'Cause I'm Going Down
There was much negativity today in the markets today. Non-farm Payrolls came in at -524,000 jobs. This follows November which when the economy lost 533,000 jobs. The employment rate rose to a 15-year high 7.2%. Average Weekly Hours came in at an all-time low 33.3 hours. The so-called diffusion index, which reports how far-reaching job losses are through the broad economy reported significant employment declines in nearly every sector (government and healthcare / education were the only sectors reporting gains).
Large job losses in the broad economy promise to perpetuate the negative feedback loop. As home prices decline, fewer homes are purchased, fewer building materials and appliances are purchased. The financial industry suffered from a lack of lending business, Americans lose their jobs. Fewer people are in the pool of potential home buyers. Home prices fall and the cycle repeats itself. The longer it takes for home prices to find a bottom at which potential home buyers feel confident enough to buy a home, for banks to lend (for non-conforming mortgages), for investors to purchase private-label mortgage-backed securities (necessary to provide capital for mortgages, the longer and deeper the recessions will be. The problem is that no one in Congress, on either side of the aisle, will admit that some (maybe many or most) of distressed home owners cannot and should not be saved. When one is experiencing pain from a malignant growth, taking aspirin for the pain is not the answer. At some point, painful surgery is necessary. The longer one waits to address the real problem, the worse the problem becomes and the prospects for a recovery diminishes.
Large job losses in the broad economy promise to perpetuate the negative feedback loop. As home prices decline, fewer homes are purchased, fewer building materials and appliances are purchased. The financial industry suffered from a lack of lending business, Americans lose their jobs. Fewer people are in the pool of potential home buyers. Home prices fall and the cycle repeats itself. The longer it takes for home prices to find a bottom at which potential home buyers feel confident enough to buy a home, for banks to lend (for non-conforming mortgages), for investors to purchase private-label mortgage-backed securities (necessary to provide capital for mortgages, the longer and deeper the recessions will be. The problem is that no one in Congress, on either side of the aisle, will admit that some (maybe many or most) of distressed home owners cannot and should not be saved. When one is experiencing pain from a malignant growth, taking aspirin for the pain is not the answer. At some point, painful surgery is necessary. The longer one waits to address the real problem, the worse the problem becomes and the prospects for a recovery diminishes.
Thursday, January 8, 2009
Coming On Strong
Following correspondence with some readers regarding the value of LIBOR-based floating rate preferreds in this environment, I decided to truly delve into them to uncover, if I could, their advantages at this time. I was surprised that they are not as bad as I had thought (or as they had been). Most of them are trading at prices which would permit investors to purchase enough shares to equal the cashflow generated by purchasing the same dollar amount of preferreds offering twice the coupon. When one considers that once LIBOR rises high enough to push the floating-rate coupons above their floors (where the reside currently), there may be some value here indeed, but it is not all roses.
Pushing LIBOR high enough to get these adjustable rate preferreds above their minimum coupons may take some doing. The typical floating-rate preferred spreads its coupon between 75 and 100 basis points over three-month LIBOR (BACprE only spreads 35 basis points over three-month LIBOR). With three month LIBOR sitting at 1.35%, a sharp increase in short-term rates in necessary to get these coupons off of there floors. To make matters worse, LIBOR rates are falling. This is by design.
Typically, three-month LIBOR trades at approximately 15 basis points above Fed Funds or between 20 and 30 basis points above three-month T-Bills. The government's liquidity programs are designed to narrow the gap. One may take the view that it doesn't matter when three-month LIBOR rates rise because one is not disadvantaged in terms of cashflow on capital invested while one waits. Although this is true, a floating rate preferred which is not experiencing rising coupons may actually trade more poorly, especially if falling LIBOR rates make it push floating benchmarks further below the floor coupon.
From a trading aspect, if long-term rates rise from inflation (caused by growth or, more likely, the printing of dollars), but short-term rates do not rise or rise appreciably, prices of these floaters may suffer along with those of high-coupon fixed-rate preferreds. Any price improvements from credit spread tightening will benefit fixed and floating-rate preferreds similarly, to a point. If the Fed chooses to keep Fed Funds relatively low and the financial sector improves to where LIBOR spreads are near their "normal" levels, it is possible that their coupons will stay near or at their floors even though long-term rates and inflation is rising. This makes them imperfect inflation hedges at best, sorry Barron's. Also, since LIBOR must rise hundreds of basis points to get the floaters' coupons off their floors, we could be well into, if not through an economic cycle without ever experiencing a coupon increase.
As call dates approach, depending where new issue preferreds can be issued (if they can be issued), the high-coupon fixed-rate preferreds will have calls coming "into the money" This would cause their prices to accrete to par ($25.00). However, the floaters stuck at low coupons (they could remain low even of they rise somewhat from their floors) would have calls out of the money and may experience little in the way of price increases.
As I have said before, use these preferreds as ways to play a flatter yield curve and as a speculation the short-term rates will rise sharply. At least now, one will probably not suffer too severely if they bet incorrectly, just remember, it is not a sure bet.
One quick note, as expected BAC has decided to explicitly guarantee MER preferred stocks, However, unexpectedly BAC has left MER as a subsidiary and is not explicitly guaranteeing MER bonds or trust preferreds. The street consensus is that BAC wants to keep Merrill's large amount of debt separate from its own capital structure. S&P upgraded MER debt stating that it believes that BAC understands the importance of Merrill paying its obligations. Nothing is every easy.
Hang on for Non-farm Payrolls.
Pushing LIBOR high enough to get these adjustable rate preferreds above their minimum coupons may take some doing. The typical floating-rate preferred spreads its coupon between 75 and 100 basis points over three-month LIBOR (BACprE only spreads 35 basis points over three-month LIBOR). With three month LIBOR sitting at 1.35%, a sharp increase in short-term rates in necessary to get these coupons off of there floors. To make matters worse, LIBOR rates are falling. This is by design.
Typically, three-month LIBOR trades at approximately 15 basis points above Fed Funds or between 20 and 30 basis points above three-month T-Bills. The government's liquidity programs are designed to narrow the gap. One may take the view that it doesn't matter when three-month LIBOR rates rise because one is not disadvantaged in terms of cashflow on capital invested while one waits. Although this is true, a floating rate preferred which is not experiencing rising coupons may actually trade more poorly, especially if falling LIBOR rates make it push floating benchmarks further below the floor coupon.
From a trading aspect, if long-term rates rise from inflation (caused by growth or, more likely, the printing of dollars), but short-term rates do not rise or rise appreciably, prices of these floaters may suffer along with those of high-coupon fixed-rate preferreds. Any price improvements from credit spread tightening will benefit fixed and floating-rate preferreds similarly, to a point. If the Fed chooses to keep Fed Funds relatively low and the financial sector improves to where LIBOR spreads are near their "normal" levels, it is possible that their coupons will stay near or at their floors even though long-term rates and inflation is rising. This makes them imperfect inflation hedges at best, sorry Barron's. Also, since LIBOR must rise hundreds of basis points to get the floaters' coupons off their floors, we could be well into, if not through an economic cycle without ever experiencing a coupon increase.
As call dates approach, depending where new issue preferreds can be issued (if they can be issued), the high-coupon fixed-rate preferreds will have calls coming "into the money" This would cause their prices to accrete to par ($25.00). However, the floaters stuck at low coupons (they could remain low even of they rise somewhat from their floors) would have calls out of the money and may experience little in the way of price increases.
As I have said before, use these preferreds as ways to play a flatter yield curve and as a speculation the short-term rates will rise sharply. At least now, one will probably not suffer too severely if they bet incorrectly, just remember, it is not a sure bet.
One quick note, as expected BAC has decided to explicitly guarantee MER preferred stocks, However, unexpectedly BAC has left MER as a subsidiary and is not explicitly guaranteeing MER bonds or trust preferreds. The street consensus is that BAC wants to keep Merrill's large amount of debt separate from its own capital structure. S&P upgraded MER debt stating that it believes that BAC understands the importance of Merrill paying its obligations. Nothing is every easy.
Hang on for Non-farm Payrolls.
Monday, January 5, 2009
Meet The New Year (same as the old year)
2009 is picking up where 2008 left off. Banks are being criticized for not lending to anyone who is not a stellar credit risk and not writing non-conforming mortgages. Critics are basically bashing the banks for not engaging in the very lending practices which created the credit crisis. Why would politicians and various financial pundits demand banks engage in risky lending practices? Because it is now politically expedient to do so. The alternative would be to permit home prices to fall to levels at which banks are comfortable lending (as to not take further losses due to further declining home prices), at which potential home buyers feel comfortable purchasing a home without being upside down (owing more than it is worth) and (possibly most important) where investors are comfortable purchasing the required private-label mortgage backed securities. This is not popular with voters so politicians have chosen to try to hold back the sea. This only encourages the negative feedback loop and the housing sector (and overall economy) continues to deteriorate.
Another result is that the government continues to print money and issue debt as ways of holding back the sea. As I have written for the past two months, this has to lead to higher long-term rates at some point. Over the past several days, both the Wall Street Journal and Barron's have published articles stating similar opinions. As usual, Barron's used PIMCO to make its case. Barron's published:
"The bear market may have begun Wednesday, when prices of
30-year Treasuries fell 3%. They lost another 3% Friday. - "Get out of
Treasuries. They are very, very expensive," Mohamed El-Erian, chief
investment officer of Pacific Investment Management Co., warned
recently. Pimco runs the country's largest bond fund, Pimco Total Return
(ticker: PTTPX). - Treasuries offer little or no margin of safety if the
economy unexpectedly strengthens in 2009, or the dollar weakens
significantly, or inflation shows signs of reaccelerating. Yields on
30-year Treasuries easily could top 4% by year end"
Was I ahead of PIMCO in my prediction? As much as I would like to claim as much, I seriously doubt at. As usual, PIMCO already has engaged in strategies to take advantage of higher long-term rates and is now comfortable in making its strategy public knowledge. Yes, PIMCO is talking its book. PIMCO is probably correct and if one invested with PIMCO, one will probably do very well. Waiting for PIMCO to tell you what to do and then reacting is almost guaranteeing that you will be a day late and a dollar short.
In my last post I critiqued a Barron's article which irresponsibly stated that floating-rate preferreds are a great way to take advantage of higher interest rates and higher inflation. I shot holes in this theory by pointing out that preferred floaters have coupons which adjust off of short-term benchmarks, but trade off of long-term benchmarks as they are perpetual securities. A flattening yield curve is needed to make these vehicles perform well. I also stated that the yield curve will probably steepen as the supply of long-term debt and the printing of dollars will put pressure on the long end of the curve, but short-term rates will remain low as the Fed keeps short-term borrowing rates low for an extended period of time. Thus far, we have seen long-term rates (10-year and 30-year treasuries) rise 40 or more basis points during the past two trading sessions. However, the two-year note yield has risen only about 10 basis points. The yield curve has steepened by 30 basis points. This will probably be the trend for the next year or two.
Lastly, my opinion that investors may find better relative values in cumulative trust preferreds rather than preferred stocks due their debt components and their seniority to the government's preferred claim in the banks has caused some readers to question whether they should sell their non-cumulative preferred holdings. I do not think that the government will wipe out preferred stock dividends, though it could if it so desired. If I already owned non-cumulative preferreds, I would hold onto them, but if I had new money to invest in preferreds I would buy the trust preferreds as one is not being sufficiently rewarded in terms of yield for taking on the risks associated with a more subordinate class of preferred.
Another result is that the government continues to print money and issue debt as ways of holding back the sea. As I have written for the past two months, this has to lead to higher long-term rates at some point. Over the past several days, both the Wall Street Journal and Barron's have published articles stating similar opinions. As usual, Barron's used PIMCO to make its case. Barron's published:
"The bear market may have begun Wednesday, when prices of
30-year Treasuries fell 3%. They lost another 3% Friday. - "Get out of
Treasuries. They are very, very expensive," Mohamed El-Erian, chief
investment officer of Pacific Investment Management Co., warned
recently. Pimco runs the country's largest bond fund, Pimco Total Return
(ticker: PTTPX). - Treasuries offer little or no margin of safety if the
economy unexpectedly strengthens in 2009, or the dollar weakens
significantly, or inflation shows signs of reaccelerating. Yields on
30-year Treasuries easily could top 4% by year end"
Was I ahead of PIMCO in my prediction? As much as I would like to claim as much, I seriously doubt at. As usual, PIMCO already has engaged in strategies to take advantage of higher long-term rates and is now comfortable in making its strategy public knowledge. Yes, PIMCO is talking its book. PIMCO is probably correct and if one invested with PIMCO, one will probably do very well. Waiting for PIMCO to tell you what to do and then reacting is almost guaranteeing that you will be a day late and a dollar short.
In my last post I critiqued a Barron's article which irresponsibly stated that floating-rate preferreds are a great way to take advantage of higher interest rates and higher inflation. I shot holes in this theory by pointing out that preferred floaters have coupons which adjust off of short-term benchmarks, but trade off of long-term benchmarks as they are perpetual securities. A flattening yield curve is needed to make these vehicles perform well. I also stated that the yield curve will probably steepen as the supply of long-term debt and the printing of dollars will put pressure on the long end of the curve, but short-term rates will remain low as the Fed keeps short-term borrowing rates low for an extended period of time. Thus far, we have seen long-term rates (10-year and 30-year treasuries) rise 40 or more basis points during the past two trading sessions. However, the two-year note yield has risen only about 10 basis points. The yield curve has steepened by 30 basis points. This will probably be the trend for the next year or two.
Lastly, my opinion that investors may find better relative values in cumulative trust preferreds rather than preferred stocks due their debt components and their seniority to the government's preferred claim in the banks has caused some readers to question whether they should sell their non-cumulative preferred holdings. I do not think that the government will wipe out preferred stock dividends, though it could if it so desired. If I already owned non-cumulative preferreds, I would hold onto them, but if I had new money to invest in preferreds I would buy the trust preferreds as one is not being sufficiently rewarded in terms of yield for taking on the risks associated with a more subordinate class of preferred.
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