On Tuesday 2/24/09, I stated my belief that the government will act as an economic nanny. No large firm will be forced into a painful restructuring, much less fail. Now today we hear that AIG may get a government backstop for its CDO exposure. That's right boys and girls, if AIG's CDO bets continue to sour, the government may take the hit. I warned you.
Some of my readers and contacts took that as good news. Maybe I'm old fashioned, but I don't want my tax money to pay for bad bets of others. I am not suggesting that large firms fail and take depositors or insurance customers with them, but shareholders, who are the owners, should be wiped out as a result. The wonton bailing out of corporations sends a poor message to corporations and sets a dangerous precedent. That is, if we continue to be a capitalist nation.
Besides a Trotsky-an redistribution of the wealth, President Obama's new agenda calls for an end to government subsidy to mortgage lenders. This sent the price of SLM bonds and shares tumbling. It is also bad news for Citi, which is a large student lender. The administration acknowledged that the goal is to make the government the primary student lender. I can't wait to see the lending criteria of such an arrangement. Could we see low-income borrower receive low interest rates while more creditworthy borrowers receive higher interest rates? Why not? This is the government at work. Maybe we will have government runs automakers build government-mandated vehicles with consumers purchasing with government loans. With GM having reported a $30B annual loss for 2008 and begging for billions of dollars or more aid, anything is possible.
The next time you cheer a government bailout of a company, consider the consequences. It will be a long, long lonely recession
Thursday, February 26, 2009
Tuesday, February 24, 2009
Ladies and Gentlemen of the Jury
The markets, especially bank shares, preferreds and bonds, rallied following Fed Chairman Ben Bernanke's testimony today. Mr. Bernanke indicated that he does not believe the banks would have to be nationalized, that they had sufficient capital. At worst, Mr. Bernanke believes that banks may have to be dealt with on an individual basis, based on the results of the Treasury's forthcoming "stress test". A stress test which Mr. Bernanke states will not be a pass / fail test, but a measure of how much more funding specific banks may need. In other words, the entire bank rescue plan is jury-rigged.
First, I do not know one credible person who believed that the entire banking system would be nationalized. The believe that only demonstrates ignorance. Even the nationalization of one large bank is a gargantuan undertaking fraught with unintended consequences. A more realistic plan would be to take large equity investments in troubled banks and force their restructuring. Although the government may take equity stakes in certain banks, it appears as though forced (and necessary) restructurings are not on the table.
No large bank will be restructured. No large bank will have to face the realized losses it incurred. The worse off a bank the more money it receives. I am wondering if it truly matters in what class of securities one invests. According to Mr. Bernanke, large banks will be rescued come hell or high water. The secret to business success in America no longer consists of creating an efficient, well-run business model. The new secret to business success is to grow large enough to where a corporation can hold the nation hostage.
President Obama said strings will indeed be attached to further bank rescues (more inconsistencies from the government. I agree with the President. Not only to I agree with the President, but I will go one better. I think shareholders (who are owners of the banks after all) should share in the losses. I say this as an owner of a fair amount of unvested shares of a large troubled bank.
Some will argue that if shareholders, common or preferred, are wiped out, investors will not come bank to those areas of the market. The aftermath of Freddie and Fannie preferreds proves this can happen. However, the result will be that investors will look at the individual business models and results of a company, not just their size or systemic importance (or in the case of the GSEs, government reassurance). Institutions seeking capital from investors will have to be transparent and efficient. If shareholders are forced to share in the pain with taxpayers now, they will be make more prudent investment decisions for years to come and force institutions to better run their operations, lest they cut themselves off from the capital markets. In other words, if institutions want investor capital, it will have to earn investor trust!
Although it appears as the government will act as an economic nanny, I still believe it makes sense to go up the capital structure, just in case the government decides to do the right thing and unwind so-called zombie banks. Just because the government may not act appropriately does not mean that we should take undo risk by counting on the government to act irresponsibly and permit banks to pay dividends, etc. out of TARP money. One of these days it is going to surprise us.
First, I do not know one credible person who believed that the entire banking system would be nationalized. The believe that only demonstrates ignorance. Even the nationalization of one large bank is a gargantuan undertaking fraught with unintended consequences. A more realistic plan would be to take large equity investments in troubled banks and force their restructuring. Although the government may take equity stakes in certain banks, it appears as though forced (and necessary) restructurings are not on the table.
No large bank will be restructured. No large bank will have to face the realized losses it incurred. The worse off a bank the more money it receives. I am wondering if it truly matters in what class of securities one invests. According to Mr. Bernanke, large banks will be rescued come hell or high water. The secret to business success in America no longer consists of creating an efficient, well-run business model. The new secret to business success is to grow large enough to where a corporation can hold the nation hostage.
President Obama said strings will indeed be attached to further bank rescues (more inconsistencies from the government. I agree with the President. Not only to I agree with the President, but I will go one better. I think shareholders (who are owners of the banks after all) should share in the losses. I say this as an owner of a fair amount of unvested shares of a large troubled bank.
Some will argue that if shareholders, common or preferred, are wiped out, investors will not come bank to those areas of the market. The aftermath of Freddie and Fannie preferreds proves this can happen. However, the result will be that investors will look at the individual business models and results of a company, not just their size or systemic importance (or in the case of the GSEs, government reassurance). Institutions seeking capital from investors will have to be transparent and efficient. If shareholders are forced to share in the pain with taxpayers now, they will be make more prudent investment decisions for years to come and force institutions to better run their operations, lest they cut themselves off from the capital markets. In other words, if institutions want investor capital, it will have to earn investor trust!
Although it appears as the government will act as an economic nanny, I still believe it makes sense to go up the capital structure, just in case the government decides to do the right thing and unwind so-called zombie banks. Just because the government may not act appropriately does not mean that we should take undo risk by counting on the government to act irresponsibly and permit banks to pay dividends, etc. out of TARP money. One of these days it is going to surprise us.
Sunday, February 22, 2009
Things are Different Today
In recent weeks I have read several reports which have been decidedly gloomy. The authors would probably concede that the pictures they are painting are not cheery, but do give some reasons for which to be hopeful. However, their reasons for having hope focus on the accommodative policies which have already been undertaken by the Fed and the future effects of government stimulus. Is it that some economists and strategists do not understand how and why the economy has declined to such a distressed state?
That is unlikely, it is more likely that economists have nothing else on which to fall back, but the hope that policies which have successfully stimulative in the past will once again be effective. That to me is disturbing. It is disturbing because the stimulative policies of the recent past focused on making borrowed capital more affordable. Such policies never solved the problem, they only masked the problem. This is akin to warding off a hangover by becoming drunk again at the onset of a headache. If one can stay drunk, one never has to experience a hangover. That is until either one runs out of alcohol or dies of alcohol poisoning. The economy has run out of alcohol.
Let’s go back to early 1980s. The economy was mired in a morass of no growth due to high taxes, inflexible labor laws and prohibitively high inflation. Then Fed Chairman Paul Volcker correctly identified high inflation pressures as the culprit for the stagnant economy. Contrary to recent Fed policy he raised interest rates to stimulate the economy. The plan was to combat inflation by making it prohibitively expensive to borrow. Mr. Volcker made it difficult to lever up. That the resulting recession was necessary as it reduced demand to the point where inflation was defeated. Once inflation was defeated, the economy began a long, steady march upward.
All was fine through remainder of the 1980s. Yes there was the 1987 market crash and a recession in the early 1990s (exacerbated by the First Gulf War), but the economy experienced steady growth with mild periodic corrections. However, after the 1980s rapid recovery from the malaise of the 1970s, the public expected strong growth all of the time. Slow growth and recessions were considered the result of failed policies and not of normal economic cycles. Thus, the Fed would lower rates aggressively to stimulate the economy. The culture of borrowing was born of affordable leverage.
To the delight of consumers, free trade policies, welfare reform and an explosion of technological advances combined to have a turbocharger affect on the economy. By late 1999 public perception that the tech bubble was the new reality. Every venture with “dot com” in its title was considered can’t-miss business idea. Actual earnings or business plans (many ventures had no business plans) were of little concern to the new dot-com investors. Newer financial advisers were also sucked in. Investors of all ages loaded up on tech.
Former Fed Chairman, Alan Greenspan’s warning about “irrational exuberance” went on heeded. When he saw the economy overheating due to preposterous investor expectations he increased interest rates. That removed leverage from the economy keeping many investors on the sidelines. Companies found venture capital more difficult to obtain. Without additional venture capital, many dot-coms failed as they were never able to generate a profit. This caused the markets to take a closer look at the tech sector. What they found was a sector littered with bad businesses. As should happen in a free market economy unviable businesses were permitted to fail. Of course the public saw the bursting of the tech bubble and the following recession as a failure of policy rather than what it really was irrational behavior on the part of investors. Business (and personal) failures are normal parts of life, except when people are told that they are not.
The recession of 2001 was blamed on the new president because it made for a good sound bite. Political pundits began telling the public that they deserved a return to a “healthy” economy like they had experienced in the late 1990s. People bought into the idea that double digit growth and windfall investments were normal!
As it had done since late in the Paul Volcker era, the Fed eased to stimulate the economy, stimulation via cheap borrowing. Fed Chairman Alan Greenspan became concerned that although business activity increased, job growth remained modest (the so-called jobless recovery). Modest job growth was due to productivity gains resulting from technological advances and globalization. Fewer workers were needed to produce the required goods and service for a given amount of economic growth. That answer was politically unacceptable.
The Fed began a strategy of supercharging the economy by bring the Fed Funds rate to 1.00% was, in affect, a negative interest rate as it was below the rate of inflation. Even investors who had to pay higher-than-typical interest rates were borrowing at historically low rates. Combine that with the banks’ ability to bury exotic and subprime loans into AAA-rated securities and the recipe for disaster was not only on the stove, it was coming to a boil.
We all know what happened next. We are living it right now. What many of us many not realize is that we are not experiencing a collapse of our capitalist system (take that George Soros), but a reversion to an economy based on fundamentals and prudent lending. The last to booms (bubbles) were unsustainable economic aberrations. Efforts to re-inflate the bubble via the traditional policies of easy money have proved unsuccessful. Some businesses (possibly some banks) may fail. Many homeowners will lose their homes. These are unfortunate, but necessary occurrences. The leverage binge is over. The sooner we deal with the headache and move on the better.
That is unlikely, it is more likely that economists have nothing else on which to fall back, but the hope that policies which have successfully stimulative in the past will once again be effective. That to me is disturbing. It is disturbing because the stimulative policies of the recent past focused on making borrowed capital more affordable. Such policies never solved the problem, they only masked the problem. This is akin to warding off a hangover by becoming drunk again at the onset of a headache. If one can stay drunk, one never has to experience a hangover. That is until either one runs out of alcohol or dies of alcohol poisoning. The economy has run out of alcohol.
Let’s go back to early 1980s. The economy was mired in a morass of no growth due to high taxes, inflexible labor laws and prohibitively high inflation. Then Fed Chairman Paul Volcker correctly identified high inflation pressures as the culprit for the stagnant economy. Contrary to recent Fed policy he raised interest rates to stimulate the economy. The plan was to combat inflation by making it prohibitively expensive to borrow. Mr. Volcker made it difficult to lever up. That the resulting recession was necessary as it reduced demand to the point where inflation was defeated. Once inflation was defeated, the economy began a long, steady march upward.
All was fine through remainder of the 1980s. Yes there was the 1987 market crash and a recession in the early 1990s (exacerbated by the First Gulf War), but the economy experienced steady growth with mild periodic corrections. However, after the 1980s rapid recovery from the malaise of the 1970s, the public expected strong growth all of the time. Slow growth and recessions were considered the result of failed policies and not of normal economic cycles. Thus, the Fed would lower rates aggressively to stimulate the economy. The culture of borrowing was born of affordable leverage.
To the delight of consumers, free trade policies, welfare reform and an explosion of technological advances combined to have a turbocharger affect on the economy. By late 1999 public perception that the tech bubble was the new reality. Every venture with “dot com” in its title was considered can’t-miss business idea. Actual earnings or business plans (many ventures had no business plans) were of little concern to the new dot-com investors. Newer financial advisers were also sucked in. Investors of all ages loaded up on tech.
Former Fed Chairman, Alan Greenspan’s warning about “irrational exuberance” went on heeded. When he saw the economy overheating due to preposterous investor expectations he increased interest rates. That removed leverage from the economy keeping many investors on the sidelines. Companies found venture capital more difficult to obtain. Without additional venture capital, many dot-coms failed as they were never able to generate a profit. This caused the markets to take a closer look at the tech sector. What they found was a sector littered with bad businesses. As should happen in a free market economy unviable businesses were permitted to fail. Of course the public saw the bursting of the tech bubble and the following recession as a failure of policy rather than what it really was irrational behavior on the part of investors. Business (and personal) failures are normal parts of life, except when people are told that they are not.
The recession of 2001 was blamed on the new president because it made for a good sound bite. Political pundits began telling the public that they deserved a return to a “healthy” economy like they had experienced in the late 1990s. People bought into the idea that double digit growth and windfall investments were normal!
As it had done since late in the Paul Volcker era, the Fed eased to stimulate the economy, stimulation via cheap borrowing. Fed Chairman Alan Greenspan became concerned that although business activity increased, job growth remained modest (the so-called jobless recovery). Modest job growth was due to productivity gains resulting from technological advances and globalization. Fewer workers were needed to produce the required goods and service for a given amount of economic growth. That answer was politically unacceptable.
The Fed began a strategy of supercharging the economy by bring the Fed Funds rate to 1.00% was, in affect, a negative interest rate as it was below the rate of inflation. Even investors who had to pay higher-than-typical interest rates were borrowing at historically low rates. Combine that with the banks’ ability to bury exotic and subprime loans into AAA-rated securities and the recipe for disaster was not only on the stove, it was coming to a boil.
We all know what happened next. We are living it right now. What many of us many not realize is that we are not experiencing a collapse of our capitalist system (take that George Soros), but a reversion to an economy based on fundamentals and prudent lending. The last to booms (bubbles) were unsustainable economic aberrations. Efforts to re-inflate the bubble via the traditional policies of easy money have proved unsuccessful. Some businesses (possibly some banks) may fail. Many homeowners will lose their homes. These are unfortunate, but necessary occurrences. The leverage binge is over. The sooner we deal with the headache and move on the better.
Friday, February 20, 2009
That Thing You Do
On 2/17/09 I wrote about the so-called "Bond Vigilantes". My belief was that market participants would beat the living daylights out of the banks, especially those considered to be the most troubled until the government does something definitive to address toxic assets (calling some of these assets is being very kind). Market participants and the Obama administration then engaged in a dangerous game of chicken. The administration had better understand that the market will not blink. It will take an institution down if it believes it to be a failed entity. Share prices of certain banks reflect this view.
The administration finally, late this afternoon, said something. Robert Gibbs, a White House spokesman stated that the administration: "continues to strongly believe that a privately held banking system is the correct way to go." Well I'm glad to hear that. Did anyone really believe that nationalization was the best way to go as a rule?
Although its is comforting to hear that the government is not ready to transform the country to a people's republic, the statement did little to satisfy the capital markets. The markets want action. They do not want mark-to-market change. They do not want positive rhetoric. They want to know what assets are on bank balance sheets, what they are expected to be worth on a long-term basis and the want to know what will be done with banks which have an over-abundance of glow in the dark assets. They want action, not talk. The market is saying DO SOMETHING! The problem is, the government does not know what to do. Buying assets at prices which reflect even long-term prospects could sink some banks. If assets could have been purchased, former Treasury Secretary Paulson would have done so last year via TARP.
As if fear of the unknown was not enough to cripple the markets, Senator Chris Dodd (Remember him? He is the guy who accepted sweetheart mortgage deals from Countrywide and, along with Congressman Barney Frank, made the suspension of FNM and FRE preferred dividends a contingent of a Treasury rescue of the GSEs) told Bloomberg News that some banks may have to be temporarily nationalized. I don't know who is dumber, Mr. Dodd or those who elected him?
I don't think Mr. Dodd is dumb because of what he said. There could be a bank which needs nationalization (government administration is more likely), but why say so during a trading day when it is the administration which makes that decision, not Mr. Dodd. Sometimes it is better that people think you a fool than to open your mouth and prove it. An unnamed source at Treasury told Bloomberg News that Secretary Geithner will announce a plan sometime next week. He next announcement had best be better than his last or he will be dealing with a financial system collapse.
The word nationalization is now in vogue. However, most people do not understand what a true nationalization entails. In true nationalization, the government seizes a an institution, manages it and guarantees its debt and counterparty obligations. This is not likely to occur. For one, it is expensive. Secondly, it creates a dangerous unintended consequence. A nationalized bank would be backed explicitly by the government. The result would be deposits guaranteed regardless of amount because the bank itself would be explicitly guaranteed. Depositors would be incentivized to withdraw their money from smaller, non-guaranteed banks (which may not be too important to fail) and move to the new nationalized bank. The possible result are bank runs and failures around the country.
More likely is some version of AIG and or the GSEs. In the case of a troubled bank, the government could converts their preferreds to common equity to increase that bank's tangible common equity (TCE) thereby diluting common shares, making them essentially worthless. The next step could be a suspension of preferred equity dividends (so much for investing along side the government). However, debt securities, including trust preferreds, could be battered, but survive. It is probably a good idea, for those who still wish to invest in troubled banks, to move up the capital structure from common or preferred equity to at least the trust preferred level. At that level, one would still participate in any business recovery, but could be more protected in a less than optimal scenario.
The administration finally, late this afternoon, said something. Robert Gibbs, a White House spokesman stated that the administration: "continues to strongly believe that a privately held banking system is the correct way to go." Well I'm glad to hear that. Did anyone really believe that nationalization was the best way to go as a rule?
Although its is comforting to hear that the government is not ready to transform the country to a people's republic, the statement did little to satisfy the capital markets. The markets want action. They do not want mark-to-market change. They do not want positive rhetoric. They want to know what assets are on bank balance sheets, what they are expected to be worth on a long-term basis and the want to know what will be done with banks which have an over-abundance of glow in the dark assets. They want action, not talk. The market is saying DO SOMETHING! The problem is, the government does not know what to do. Buying assets at prices which reflect even long-term prospects could sink some banks. If assets could have been purchased, former Treasury Secretary Paulson would have done so last year via TARP.
As if fear of the unknown was not enough to cripple the markets, Senator Chris Dodd (Remember him? He is the guy who accepted sweetheart mortgage deals from Countrywide and, along with Congressman Barney Frank, made the suspension of FNM and FRE preferred dividends a contingent of a Treasury rescue of the GSEs) told Bloomberg News that some banks may have to be temporarily nationalized. I don't know who is dumber, Mr. Dodd or those who elected him?
I don't think Mr. Dodd is dumb because of what he said. There could be a bank which needs nationalization (government administration is more likely), but why say so during a trading day when it is the administration which makes that decision, not Mr. Dodd. Sometimes it is better that people think you a fool than to open your mouth and prove it. An unnamed source at Treasury told Bloomberg News that Secretary Geithner will announce a plan sometime next week. He next announcement had best be better than his last or he will be dealing with a financial system collapse.
The word nationalization is now in vogue. However, most people do not understand what a true nationalization entails. In true nationalization, the government seizes a an institution, manages it and guarantees its debt and counterparty obligations. This is not likely to occur. For one, it is expensive. Secondly, it creates a dangerous unintended consequence. A nationalized bank would be backed explicitly by the government. The result would be deposits guaranteed regardless of amount because the bank itself would be explicitly guaranteed. Depositors would be incentivized to withdraw their money from smaller, non-guaranteed banks (which may not be too important to fail) and move to the new nationalized bank. The possible result are bank runs and failures around the country.
More likely is some version of AIG and or the GSEs. In the case of a troubled bank, the government could converts their preferreds to common equity to increase that bank's tangible common equity (TCE) thereby diluting common shares, making them essentially worthless. The next step could be a suspension of preferred equity dividends (so much for investing along side the government). However, debt securities, including trust preferreds, could be battered, but survive. It is probably a good idea, for those who still wish to invest in troubled banks, to move up the capital structure from common or preferred equity to at least the trust preferred level. At that level, one would still participate in any business recovery, but could be more protected in a less than optimal scenario.
Tuesday, February 17, 2009
Pressure
Today I conducted a conference call with a branch office in Chicago. Following comments I made regarding where preferreds rank in the capital structure and why the markets are beating the tar out of bonds, preferreds and common shares of certain banks, I was pressured to comment on my own firm. This in spite of my stating (several times) that I cannot do so. I did not appreciate the pressure. I hope all of my readers understand that I am really not at liberty to discuss specifics regarding my own firm.
All I can say is that the markets do not believe that all of the toxicity has been addresses within certain banks. Judging by the dollar amounts mentioned by today's call participants, it appears that many advisers and clients are greatly underestimating the toxicity on bank balance sheets. From the information I have gathered, the worst offenders could have several hundred billion dollars of toxic assets on their balance sheets. Numbers approaching a trillion dollars have been mentioned for some firms, but I have no way to verify this. The Street sure doesn't like certain banks. It would be naive to think that, at this stage of the game, that the street was completely irrational.
The autos announced their "restructuring" plans. The plans amount to little more than more layoffs, requests for billions of dollars worth of more aid and warnings that bankruptcies would be the most costly option. GM and Chrysler are basically telling Congress and the Obama administration that the least change possible is best. So much for change.
The Detroit business model is broken. Corporate structures and labor agreements make lower priced vehicles money-losers. Therefore, these vehicles receive little in the way of R&D. Unfortunately for Detroit, smaller, cheaper vehicles are what are in demand. Even Chrysler, which was the domestic small car leader (Chrysler small engines were considered to be so good that BMW used a version of the Chrysler four cylinder engine is the first generation of the modern Mini), is knocking on FIAT's door for small car development. FIAT has been out of the U.S. market since the 1980s because it could not compete.
Fixed income investors beware. Just because GM does not file for a traditional bankruptcy, it is unlikely that bondholders receive 100 cents on the dollar for their bonds. Also, any compensation resulting from a government-sponsored restructuring may not be all cash. It is likely that bondholders would receive some combination of cash, new shares and, perhaps, new debt. Keep in mind that all existing Chrysler Financial and Daimler Chrysler bonds are obligations of Daimler AG.
Que Pasa, Chica?
All I can say is that the markets do not believe that all of the toxicity has been addresses within certain banks. Judging by the dollar amounts mentioned by today's call participants, it appears that many advisers and clients are greatly underestimating the toxicity on bank balance sheets. From the information I have gathered, the worst offenders could have several hundred billion dollars of toxic assets on their balance sheets. Numbers approaching a trillion dollars have been mentioned for some firms, but I have no way to verify this. The Street sure doesn't like certain banks. It would be naive to think that, at this stage of the game, that the street was completely irrational.
The autos announced their "restructuring" plans. The plans amount to little more than more layoffs, requests for billions of dollars worth of more aid and warnings that bankruptcies would be the most costly option. GM and Chrysler are basically telling Congress and the Obama administration that the least change possible is best. So much for change.
The Detroit business model is broken. Corporate structures and labor agreements make lower priced vehicles money-losers. Therefore, these vehicles receive little in the way of R&D. Unfortunately for Detroit, smaller, cheaper vehicles are what are in demand. Even Chrysler, which was the domestic small car leader (Chrysler small engines were considered to be so good that BMW used a version of the Chrysler four cylinder engine is the first generation of the modern Mini), is knocking on FIAT's door for small car development. FIAT has been out of the U.S. market since the 1980s because it could not compete.
Fixed income investors beware. Just because GM does not file for a traditional bankruptcy, it is unlikely that bondholders receive 100 cents on the dollar for their bonds. Also, any compensation resulting from a government-sponsored restructuring may not be all cash. It is likely that bondholders would receive some combination of cash, new shares and, perhaps, new debt. Keep in mind that all existing Chrysler Financial and Daimler Chrysler bonds are obligations of Daimler AG.
Que Pasa, Chica?
Friday, February 13, 2009
Bank Vigilantes
Those of us who were in the business remember the term "Bond Vigilante". The Bond Vigilantes were participants in the U.S Treasury market who put the kibosh on President Bill Clinton's spending plans by pushing the yield of long dated treasuries higher. This forced the President to scale bank spending and instead attack the budget deficit. This prompted presidential adviser James Carville to state:
"I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.''
The Vigilante's, or their descendents are back, but U.S. treasuries are not their targets. It's the banks. Bond Vigilantes are now Bank Vigilantes.
James Carville was not joking when he described the power of the bond market. More than any other area of the capital markets, the fixed income arena exerts the most influence over the economy, the President, Congress and corporations. The bond market is making itself heard loud and clear that it wants toxic asset exposure by banks revealed and it wants those toxic assets of bank balance sheets or it will take its capital elsewhere. Until the Bank Vigilantes feel comfortable, banks will have to go to the government for capital. This is all very frustrating for our new President and his treasury secretary, Tim Geithner.
The government has chosen to engage in a game of chicken with the Bank Vigilantes. The new players in D.C. had best use caution when attempting to stare down the bond market because it does not blink. The man who knows this is Fed Chairman Ben Bernanke. He has stated at several venues that there needs to be a mechanism to deal with an orderly dissolution of a large, systemically-important institution. Mr. Bernanke knows that the bond market (including preferred securities) will withhold investing capital in banks which it believes may not be viable. Why take the risk. Unlike some pundits, the Bank Vigilantes do not take comfort investing along side the government in the preferred market. They do not want to risk a GSE preferred share wipe out. The first bank which comes clean by clearing out its toxic assets and throws off its TARP yoke will attract capital.
If it is that simple, why don't banks just bite the bullet and pay back TARP and become more transparent? Some are. J.P. Morgan, Goldman Sachs and Morgan Stanley are said to be considering paying back their TARP preferred investments. Why don't other large institutions do the same? If one thinks about it, the answer becomes very apparent. They cannot. This is what has prevented both former treasury secretary, Hank Paulson and current treasury secretary, Hank Paulson from enacting a workable rescue. Thus far, the government has thrown money at the problem hoping to pacify the Bank Vigilantes. The Vigilantes will have none of it. One bank CEO suggested amortizing the losses over time. This may not work because the Bank Vigilantes do not want to worry about unknown, but continuing losses. They abhor the unknown. What is frightening is that the Treasury probably has a fairly good idea what these toxic assets will be worth down the road (versus their very low current market prices), but cannot purchase toxic assets, even at their so-called "hold-to-maturity" values because values are likely sufficiently low to cripple or collapse a bank.
What happens next? Unless the Bank Vigilantes have a change of heart or the government can find a way of pacifying them without forcing a bank to acknowledge losses (neither are likely) troubled banks are going to have to face the music. Hopefully Mr. Bernanke's mechanism will be in place by then.
"I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.''
The Vigilante's, or their descendents are back, but U.S. treasuries are not their targets. It's the banks. Bond Vigilantes are now Bank Vigilantes.
James Carville was not joking when he described the power of the bond market. More than any other area of the capital markets, the fixed income arena exerts the most influence over the economy, the President, Congress and corporations. The bond market is making itself heard loud and clear that it wants toxic asset exposure by banks revealed and it wants those toxic assets of bank balance sheets or it will take its capital elsewhere. Until the Bank Vigilantes feel comfortable, banks will have to go to the government for capital. This is all very frustrating for our new President and his treasury secretary, Tim Geithner.
The government has chosen to engage in a game of chicken with the Bank Vigilantes. The new players in D.C. had best use caution when attempting to stare down the bond market because it does not blink. The man who knows this is Fed Chairman Ben Bernanke. He has stated at several venues that there needs to be a mechanism to deal with an orderly dissolution of a large, systemically-important institution. Mr. Bernanke knows that the bond market (including preferred securities) will withhold investing capital in banks which it believes may not be viable. Why take the risk. Unlike some pundits, the Bank Vigilantes do not take comfort investing along side the government in the preferred market. They do not want to risk a GSE preferred share wipe out. The first bank which comes clean by clearing out its toxic assets and throws off its TARP yoke will attract capital.
If it is that simple, why don't banks just bite the bullet and pay back TARP and become more transparent? Some are. J.P. Morgan, Goldman Sachs and Morgan Stanley are said to be considering paying back their TARP preferred investments. Why don't other large institutions do the same? If one thinks about it, the answer becomes very apparent. They cannot. This is what has prevented both former treasury secretary, Hank Paulson and current treasury secretary, Hank Paulson from enacting a workable rescue. Thus far, the government has thrown money at the problem hoping to pacify the Bank Vigilantes. The Vigilantes will have none of it. One bank CEO suggested amortizing the losses over time. This may not work because the Bank Vigilantes do not want to worry about unknown, but continuing losses. They abhor the unknown. What is frightening is that the Treasury probably has a fairly good idea what these toxic assets will be worth down the road (versus their very low current market prices), but cannot purchase toxic assets, even at their so-called "hold-to-maturity" values because values are likely sufficiently low to cripple or collapse a bank.
What happens next? Unless the Bank Vigilantes have a change of heart or the government can find a way of pacifying them without forcing a bank to acknowledge losses (neither are likely) troubled banks are going to have to face the music. Hopefully Mr. Bernanke's mechanism will be in place by then.
Wednesday, February 11, 2009
I Hate Everything About You
Former Hedge Fund Manager, Andy Kessler, has published and excellent article in the Fberuary 10th edition if the Wall Street Journal explaining why the markets did nit like what Treasury Secretary Tim Geithner had to say (or what he didn't say). Here are some excerpts:
"The Treasury secretary seems stuck on keeping the banks we have in place. But we don't need zombie banks overstuffed with nonperforming loans -- ask the Japanese."
"Mr. Geithner wants to "stress test" banks to see which are worth saving. The market already has. Despite over a trillion in assets, Citigroup is worth a meager $18 billion, Bank of America only $28 billion. The market has already figured out that the banks and their accountants haven't fessed up to bad loans and that their shareholders are toast."
"Second, Mr. Geithner wants to use up to $1 trillion to back new car loans, home loans and student loans. That's noble, but incredibly market distorting. Who gets these loans? Will banks be forced to loan to those with bad credit? Who sets loan rates? Doesn't this just set up another credit squeeze when government guarantees are lifted?"
"The first iteration of the Troubled Asset Relief Program (TARP) last year was to buy these bad loans and derivatives. It didn't work. Nothing was bought when it became clear that paying face value was a taxpayer giveaway to banks, but paying market prices for this stuff would cause huge equity write-downs, wiping out banks which would be left with negative equity and effective insolvency."
"Mr. Geithner should instead use his "stress test" and nationalize the dead banks via the FDIC -- but only for a day or so."
"First, strip out all the toxic assets and put them into a holding tank inside the Treasury. Then inject $300 billion in fresh equity for both Citi and Bank of America. Create 10 billion new shares of each of the companies to replace the old ones. The book value of each share could be $30. Very quickly, a new board of directors should be created and a new management team hired. Here's the tricky part: Who owns the shares? Politics will kill a nationalized bank. So spin them out immediately."
Readers will recognize that Mr. Kessler and I are on the same page with regards to the banks and how to get out of this crisis. Readers should pay special attention to his Japan reference. With the piggy bank known as one's home empty and traditional lending standards back in force, it will be a long time before economic activity based on consumer earned income, rather than the pyramid scheme of every increasing lending via securitization, lifts the economy into some semblance of on trend growth. The next decade may very well be lost.
"The Treasury secretary seems stuck on keeping the banks we have in place. But we don't need zombie banks overstuffed with nonperforming loans -- ask the Japanese."
"Mr. Geithner wants to "stress test" banks to see which are worth saving. The market already has. Despite over a trillion in assets, Citigroup is worth a meager $18 billion, Bank of America only $28 billion. The market has already figured out that the banks and their accountants haven't fessed up to bad loans and that their shareholders are toast."
"Second, Mr. Geithner wants to use up to $1 trillion to back new car loans, home loans and student loans. That's noble, but incredibly market distorting. Who gets these loans? Will banks be forced to loan to those with bad credit? Who sets loan rates? Doesn't this just set up another credit squeeze when government guarantees are lifted?"
"The first iteration of the Troubled Asset Relief Program (TARP) last year was to buy these bad loans and derivatives. It didn't work. Nothing was bought when it became clear that paying face value was a taxpayer giveaway to banks, but paying market prices for this stuff would cause huge equity write-downs, wiping out banks which would be left with negative equity and effective insolvency."
"Mr. Geithner should instead use his "stress test" and nationalize the dead banks via the FDIC -- but only for a day or so."
"First, strip out all the toxic assets and put them into a holding tank inside the Treasury. Then inject $300 billion in fresh equity for both Citi and Bank of America. Create 10 billion new shares of each of the companies to replace the old ones. The book value of each share could be $30. Very quickly, a new board of directors should be created and a new management team hired. Here's the tricky part: Who owns the shares? Politics will kill a nationalized bank. So spin them out immediately."
Readers will recognize that Mr. Kessler and I are on the same page with regards to the banks and how to get out of this crisis. Readers should pay special attention to his Japan reference. With the piggy bank known as one's home empty and traditional lending standards back in force, it will be a long time before economic activity based on consumer earned income, rather than the pyramid scheme of every increasing lending via securitization, lifts the economy into some semblance of on trend growth. The next decade may very well be lost.
Tuesday, February 10, 2009
Don't Let Me Down
" Oh Timmy, we had such high hopes for you. You are such a disappointment."
This is the message the markets sent to new treasury secretary Tim Geithner and his rather opaque rescue plan. Other than stating that the government will use copious amounts of money to purchase various asset backed securities and to somehow (details were not given) to encourage private investors to invest along side the government in hundreds of billions of toxic assets currently populating bank balance sheets. Conspicuously absent from today's announcement is how prices of these assets will be determined and who will incur losses.
The street abhors the unknown. It wants bad assets of bank balance sheets, losses realized by either banks (with weak institutions being dissolved or merged with other firms), the government or a combination of the two. Mr. Geithner did not state how toxic assets would be removed from bank balance sheets. This is because he has no idea how to accomplish this without either the banks or the taxpayer (government) taking losses, and losses are there to be had.
The problem stems from determining what should be paid for complex asset-backed securities, such as CDOs. The assets are plain-vanilla mortgage pass-thrus. Some are backed by complicated pools of collateral. Others are backed by other CDOs and are known as CDO-squared. Determining the values of these vehicles is extremely difficult. Although the exact value of these assets are difficult to ascertain, it is widely agreed upon that many (if not most) of these assets are not worth (nor will they ever be worth) par. Another problem, especially for distressed institutions, is that selling these assets, whether it be to speculators or to a bad bank, at prices much below par could lead to insolvency. If the government purchases these assets at or near par it would likely lock in losses. So instead of purging banks of these bad assets we get more reality avoidance. Around and around we go.
The markets also want the government out of the bank support business. The opinion espoused by some pundits that investors should be comforted by investing along side the government is not shared by the majority of market participants. One only need look at the markets reaction to various news items. Every time it appears that government assistance and involvement for the banks will increase and be prolonged the market or the securities issued by the bank in question will react negatively. When, as with Goldman Sachs when it announced its intention to pay back TARP funds early thereby ending government involvement in the firm, Common and preferred share prices rose, as did bond prices. The Street fears politically-driven government decisions.
Another unsettling development for investors holding securities of more troubled banks are comments made by Fed Chairman Ben Bernanke that a mechanism must be put in place to facilitate the orderly dissolution of large, systemically-significant institutions. This could mean that no institution is to big to fail. Investors should keep this in mind when investing in large, troubled institutions, especially far down the capital structure. Quality is king and senior equals safety. Buy CDs, Muni revenue bonds and high quality GOs. Buy corporate bonds of the biggest and best companies in their respective sectors (I like JPM, Wells, PNC and USB) and ladder or barbell. With a ladder, overweight the belly of the curve (5-years or so) and do not extend past 10 years. For a barbell, overweight the short end with CDs as much as you can adding callable agency bonds to round out that portion of the barbell. High quality bank bonds JPM, WFC, PNC and USB out in the 10-year area. Trust preferreds are aggressive investments and non-cumulative preferred equities are speculative. Economic conditions are likely to put more pressure on banks in the coming months.
The following is the link to Treasury Secretary Geithner's proposed rescue plan (conditions for further bank assistance are not necessarily equity investor friendly):
http://financialstability.gov/docs/fact-sheet.pdf
This is the message the markets sent to new treasury secretary Tim Geithner and his rather opaque rescue plan. Other than stating that the government will use copious amounts of money to purchase various asset backed securities and to somehow (details were not given) to encourage private investors to invest along side the government in hundreds of billions of toxic assets currently populating bank balance sheets. Conspicuously absent from today's announcement is how prices of these assets will be determined and who will incur losses.
The street abhors the unknown. It wants bad assets of bank balance sheets, losses realized by either banks (with weak institutions being dissolved or merged with other firms), the government or a combination of the two. Mr. Geithner did not state how toxic assets would be removed from bank balance sheets. This is because he has no idea how to accomplish this without either the banks or the taxpayer (government) taking losses, and losses are there to be had.
The problem stems from determining what should be paid for complex asset-backed securities, such as CDOs. The assets are plain-vanilla mortgage pass-thrus. Some are backed by complicated pools of collateral. Others are backed by other CDOs and are known as CDO-squared. Determining the values of these vehicles is extremely difficult. Although the exact value of these assets are difficult to ascertain, it is widely agreed upon that many (if not most) of these assets are not worth (nor will they ever be worth) par. Another problem, especially for distressed institutions, is that selling these assets, whether it be to speculators or to a bad bank, at prices much below par could lead to insolvency. If the government purchases these assets at or near par it would likely lock in losses. So instead of purging banks of these bad assets we get more reality avoidance. Around and around we go.
The markets also want the government out of the bank support business. The opinion espoused by some pundits that investors should be comforted by investing along side the government is not shared by the majority of market participants. One only need look at the markets reaction to various news items. Every time it appears that government assistance and involvement for the banks will increase and be prolonged the market or the securities issued by the bank in question will react negatively. When, as with Goldman Sachs when it announced its intention to pay back TARP funds early thereby ending government involvement in the firm, Common and preferred share prices rose, as did bond prices. The Street fears politically-driven government decisions.
Another unsettling development for investors holding securities of more troubled banks are comments made by Fed Chairman Ben Bernanke that a mechanism must be put in place to facilitate the orderly dissolution of large, systemically-significant institutions. This could mean that no institution is to big to fail. Investors should keep this in mind when investing in large, troubled institutions, especially far down the capital structure. Quality is king and senior equals safety. Buy CDs, Muni revenue bonds and high quality GOs. Buy corporate bonds of the biggest and best companies in their respective sectors (I like JPM, Wells, PNC and USB) and ladder or barbell. With a ladder, overweight the belly of the curve (5-years or so) and do not extend past 10 years. For a barbell, overweight the short end with CDs as much as you can adding callable agency bonds to round out that portion of the barbell. High quality bank bonds JPM, WFC, PNC and USB out in the 10-year area. Trust preferreds are aggressive investments and non-cumulative preferred equities are speculative. Economic conditions are likely to put more pressure on banks in the coming months.
The following is the link to Treasury Secretary Geithner's proposed rescue plan (conditions for further bank assistance are not necessarily equity investor friendly):
http://financialstability.gov/docs/fact-sheet.pdf
Monday, February 9, 2009
Nowhere Man
This past weekend, Barron's published two articles pertaining to the government's involvement in the banks. One article discussed the advantage of buying non-cumulative preferreds instead of common equity as a speculation for possible gains should the bank in question recover from the current financial crisis. That part of the article makes sense. With some of these non-cumulative preferreds selling at between 35 and 50 cents on the dollar and yields near or above 20%, non-cumulative preferreds may be a viable alternative to common equity. The article drifts off base after that.
The article repeats the Bill Gross mantra that if the government owns preferred shares, investors are protected by investing along side the government. With the government investing at the preferred level because it had to, to increase banks' Tier-1 capital (not because it wanted to) and giving itself a cumulative feature, having the government along side you is like going into business with the mob assuming that the local don will treat you as he treats himself when the operation goes south. When one invests at the preferred stock level, one is a part owner of the company and not a creditor. When things get tough, creditors get paid (hopefully) at the expense of owner distributions. This is not to say that preferred stock dividends will not be paid, but why take the risk? At least get to the trust preferred level to become a creditor. Hope that the government will take care of you because it owns preferreds (which the dividend is a drop in the bucket when considering government dollars) is not a strategy.
The other article discussed how further government assistance for banks to could favor depositors over investors. The article suggests that troubled banks could be restructured in a way in which investors, even bond investors are not made whole. The funny thing is, only one person mentioned this article. After all, this is a negative article. This is a case of seeing what one wants to see.
This article may not be any more correct than the positive article about preferreds, nut it may not be any more incorrect. My point is that this is the most severe financial crisis since the 1930s. The implications of government and private sector policies and actions should not be taken lightly.
GM and Chrysler could be subject to a government restructuring. If that ends up being the case it is very possible that the government forces investors, even senior bond investors, to accept less than 100 cents on the dollar. Bloomberg News reported today that government lawyers are working to ensure that the government has the top claim with regard to compensation in a restructuring of the auto makers. Invest along side the government? Right.
The Associated Press published an article about the latest bank rescue scheme and the plan to purchase bad assets from the banks which includes opinions and comments from various market participants. They comments are not dissimilar from what I have written previously. Take a gander:
"The first loss has got to be the government's," said Wall Street veteran Muriel Siebert, who runs the brokerage Muriel Siebert & Co. "Maybe the first 25 percent of losses. We don't know what's in some of those bonds."
"Billionaire Wilbur Ross, who runs the private equity firm WL Ross & Co., said investors want to know how much risk the government will accept if the investments go sour, and how much money the government is willing to put up — likely in the way of low-interest loans."
"And any sort of financing is something I would be interested in," said Jeffrey Gundlach, chief investment officer of Los Angeles-based money management firm The TCW Group. "There are distressed assets that I would like to buy now but I can hardly get anyone to lend me any money in the current environment."
"I want to see the incentives and the restrictions," said Jacob Benaroya, managing partner of New Jersey-based Biltmore Capital Group, a hedge fund that's buying up to $100 million in mortgage debt per year. For example, he said, he's unlikely to be interested in buying loans that must be held for 30 years.
"Investors want to know more about what those guarantees will be. Stephen L. Nesbitt, whose firm Cliffwater LLC advises clients considering alternative investments, said people want returns of about 20 percent before they will buy into really risky, distressed debt."
"They need help from the government to get there," Nesbitt said. "Either by increasing the return or decreasing the risk."
"Why would anyone want to buy these assets at inflated prices?" said Bill Fleckenstein, a Seattle-based hedge fund manager. "There's this argument that the banks can't sell at market prices because the market price is depressed. Well, that's what the market price is.""
"Lynn Tilton of the private equity firm Patriarch Partners said she wants to know what the government will consider a "bad asset" under this deal. There has to be some effort to find a real value, she said."
There you have it. Investors may consider buying troubled assets, if the government limits losses, provides cheap financing and they want to buy at fire sale prices. Simple eh? Godspeed Mr. Geithner.
The article repeats the Bill Gross mantra that if the government owns preferred shares, investors are protected by investing along side the government. With the government investing at the preferred level because it had to, to increase banks' Tier-1 capital (not because it wanted to) and giving itself a cumulative feature, having the government along side you is like going into business with the mob assuming that the local don will treat you as he treats himself when the operation goes south. When one invests at the preferred stock level, one is a part owner of the company and not a creditor. When things get tough, creditors get paid (hopefully) at the expense of owner distributions. This is not to say that preferred stock dividends will not be paid, but why take the risk? At least get to the trust preferred level to become a creditor. Hope that the government will take care of you because it owns preferreds (which the dividend is a drop in the bucket when considering government dollars) is not a strategy.
The other article discussed how further government assistance for banks to could favor depositors over investors. The article suggests that troubled banks could be restructured in a way in which investors, even bond investors are not made whole. The funny thing is, only one person mentioned this article. After all, this is a negative article. This is a case of seeing what one wants to see.
This article may not be any more correct than the positive article about preferreds, nut it may not be any more incorrect. My point is that this is the most severe financial crisis since the 1930s. The implications of government and private sector policies and actions should not be taken lightly.
GM and Chrysler could be subject to a government restructuring. If that ends up being the case it is very possible that the government forces investors, even senior bond investors, to accept less than 100 cents on the dollar. Bloomberg News reported today that government lawyers are working to ensure that the government has the top claim with regard to compensation in a restructuring of the auto makers. Invest along side the government? Right.
The Associated Press published an article about the latest bank rescue scheme and the plan to purchase bad assets from the banks which includes opinions and comments from various market participants. They comments are not dissimilar from what I have written previously. Take a gander:
"The first loss has got to be the government's," said Wall Street veteran Muriel Siebert, who runs the brokerage Muriel Siebert & Co. "Maybe the first 25 percent of losses. We don't know what's in some of those bonds."
"Billionaire Wilbur Ross, who runs the private equity firm WL Ross & Co., said investors want to know how much risk the government will accept if the investments go sour, and how much money the government is willing to put up — likely in the way of low-interest loans."
"And any sort of financing is something I would be interested in," said Jeffrey Gundlach, chief investment officer of Los Angeles-based money management firm The TCW Group. "There are distressed assets that I would like to buy now but I can hardly get anyone to lend me any money in the current environment."
"I want to see the incentives and the restrictions," said Jacob Benaroya, managing partner of New Jersey-based Biltmore Capital Group, a hedge fund that's buying up to $100 million in mortgage debt per year. For example, he said, he's unlikely to be interested in buying loans that must be held for 30 years.
"Investors want to know more about what those guarantees will be. Stephen L. Nesbitt, whose firm Cliffwater LLC advises clients considering alternative investments, said people want returns of about 20 percent before they will buy into really risky, distressed debt."
"They need help from the government to get there," Nesbitt said. "Either by increasing the return or decreasing the risk."
"Why would anyone want to buy these assets at inflated prices?" said Bill Fleckenstein, a Seattle-based hedge fund manager. "There's this argument that the banks can't sell at market prices because the market price is depressed. Well, that's what the market price is.""
"Lynn Tilton of the private equity firm Patriarch Partners said she wants to know what the government will consider a "bad asset" under this deal. There has to be some effort to find a real value, she said."
There you have it. Investors may consider buying troubled assets, if the government limits losses, provides cheap financing and they want to buy at fire sale prices. Simple eh? Godspeed Mr. Geithner.
Thursday, February 5, 2009
Fuggeddaboudit!
The story of the strong-arming of Bank of America CEO Ken Lewis by Fed Chairman Bernanke and former Treasury Secretary Paulson is quite disturbing. Apparently, Mr. Lewis and his time at Bank of America realized in Decemeber that the losses on toxic assets aT Merrill Lynch far exceeded what was expected. Although Mr. Lewis and his team could be blamed for not doing the best job of due dilligence, once the true extent of Merrill's toxic assets were known, efforts were made to abandon the deal. Enter Heavy Hank and Big Benny.
Mr. Lewis informed Mr. Paulson and Mr. Bernanke that he was considering pulling out of the deal to acquire Merrill. This was of great concern to Hank and Benny. After all, if Merrill failed, life would become very difficult for them and for the financial system. What followed could have come straight from the Sopranos.
Mr, Bernanke and Mr. Paulson first tried to reason with Mr. Lewis by pointing out that investors could have negative opinions of he and his firm. When he still balked at following through on the deal, Hank and Benny stated that if did not follow through with the acquisition of Merrill, TARP money could be scarce should Bank of America needed down the road. I spent my youth in Brooklyn. I can picture it.
Hank: Gee Ken, that's a nice bank you have here. It would be a shame if something happened to it.
Benny: You know: money is tight. It oculd be bad for you of there wasn't any left. We're not threatening. We're just saying.
We all know that the financial crisis is dire. Moody's announced today that it is going to review over $300 billion of commercial mortgage-backed securities for possible downgrades. This could be the other shoe dropping for the banks. Maybe the country would be better off if the government would acknowldege that troubled assets on bank balance sheets are going to lead to losses and decide who is going to take them, the banks or the taxpayers. However, in typical Washington fashion, the government continues to look for ways to deal with the losses with no one taking responsibility. Not going to happen. We have a nice country here. It would be a shame if something happened to it.
Mr. Lewis informed Mr. Paulson and Mr. Bernanke that he was considering pulling out of the deal to acquire Merrill. This was of great concern to Hank and Benny. After all, if Merrill failed, life would become very difficult for them and for the financial system. What followed could have come straight from the Sopranos.
Mr, Bernanke and Mr. Paulson first tried to reason with Mr. Lewis by pointing out that investors could have negative opinions of he and his firm. When he still balked at following through on the deal, Hank and Benny stated that if did not follow through with the acquisition of Merrill, TARP money could be scarce should Bank of America needed down the road. I spent my youth in Brooklyn. I can picture it.
Hank: Gee Ken, that's a nice bank you have here. It would be a shame if something happened to it.
Benny: You know: money is tight. It oculd be bad for you of there wasn't any left. We're not threatening. We're just saying.
We all know that the financial crisis is dire. Moody's announced today that it is going to review over $300 billion of commercial mortgage-backed securities for possible downgrades. This could be the other shoe dropping for the banks. Maybe the country would be better off if the government would acknowldege that troubled assets on bank balance sheets are going to lead to losses and decide who is going to take them, the banks or the taxpayers. However, in typical Washington fashion, the government continues to look for ways to deal with the losses with no one taking responsibility. Not going to happen. We have a nice country here. It would be a shame if something happened to it.
Tuesday, February 3, 2009
Mythbusters
During the past two days, there have been two articles, one in the Wall Street Journal and one on Bloomberg News discussing so-called "hybrid securities" The mention of hybrids has causes some investors to believe that the articles were referring to trust preferreds or even straight preferred equity. Let's cut through the haze.
Let's discuss the Wall Street Journal article. After reading it twice, it made little sense to me. The author first makes reference to the $700 billion hybrid market. That would have to include the trust preferreds. However, the relevance to the $25 par preferreds with which we are familiar ends here. The author mentions investor dismay that these hybrids were not retired "when expected" Since he mentioned perpetual hybrids, this posed two questions: 1) Since most $25 trust preferreds (hybrids) have maturities, what his he talking about? 2) If they are perpetual the only way they can be retired is by the issuer calling them in. Fixed income 101 states that one should never count on a call be exercised. Fixed income 205 says that an issuer will only call a security if doing so is advantageous for the issuer. Given the current credit markets environment, I could not imagine an issuer finding an advantage of calling in a security unless its coupon was so high that refinancing at today's rates offered a cost savings. My curiosity got the best of me so I contacted the author, Neil Shah or the Wall Street Journal.
Mr. Shah was happy to answer my e-mails, but what he told me made me concerned that those reporting on more esoteric securities have little understanding of their markets. The first thing I did was ask Mr. Shah to offer an example of a hybrid security which investors expected to be called. They security he used as an example as a Deutsche Bank 1,000 euro perpetual hybrid (yes, it is euro denominated), 3.875% due 2014. My eyes nearly popped out of my head. How could anyone in their right minds believe that a bank which would need to offer a five-year bond of at least 6.00%, if not higher, in today's environment call in a hybrid with a 3.875% coupon? Mr. Shah insists that investors expected this security and others like it to be called. My colleagues and I would be anxious to be the other side of these investors' trades. We could probably make a nice living this way, albeit for a short period of time as they would soon run out of capital. Mr. Shah also insisted that similar securities (with similar coupons) have been called in during the past year. Skeptical, we looked into this. We could not find an example. Mr. Shah couldn't or wouldn't offer examples. This myth was busted.
Today, Bloomberg News discussed hybrids. Although the securities discussed by Bloomberg are more closely related to the more familiar $25 trust preferreds, the article was about a different kind of structure.
The Bloomberg article discussed how hybrid securities may stop paying interest if a bank was nationalized. The securities being referred to are $1,000 trust securities. These are essentially trust preferreds which trade and look like corporate bonds. As with $25 trust preferreds, they are kinds of junior subordinate debt. The article is correct that in the case of a nationalization, hybrid interest payments could be stopped. They could be stopped permanently. They could be stopped temporarily. However, this could be true of straight preferreds (non-cumulative preferred equity), common shares and even senior debt.
In the case of a nationalization, the government could force what is known as a cram down. A cram down results in investors receiving less than par for their securities. The more senior one's securities are, the more one will receive. In the case of a cram down, investors have little recourse but to take what they get. Trust securities will always fair better than common and preferred equity and will always fair worse than more senior debt. The article was right to express concern over the treatment of trust securities in the case of a nationalization, but it should have mentioned that more subordinate securities are even more vulnerable.
The Bloomberg article, although not really false, appeared to foster a myth that hybrids were especially vulnerable to a nationalization. In actuality, non-cumulative preferred equity and common shares are even more vulnerable and even senior debt is may not be immune. The bottom line is that if one thinks that a true nationalization is possible for a bank, one should look elsewhere for investment opportunities. Although the nationalization of troubled banks is possible, it is an action of last resort as it would be expensive and cumbersome to seize a large bank. I would have to say that the myth that hybrids are an especially vulnerable asset class has been busted.
Let's discuss the Wall Street Journal article. After reading it twice, it made little sense to me. The author first makes reference to the $700 billion hybrid market. That would have to include the trust preferreds. However, the relevance to the $25 par preferreds with which we are familiar ends here. The author mentions investor dismay that these hybrids were not retired "when expected" Since he mentioned perpetual hybrids, this posed two questions: 1) Since most $25 trust preferreds (hybrids) have maturities, what his he talking about? 2) If they are perpetual the only way they can be retired is by the issuer calling them in. Fixed income 101 states that one should never count on a call be exercised. Fixed income 205 says that an issuer will only call a security if doing so is advantageous for the issuer. Given the current credit markets environment, I could not imagine an issuer finding an advantage of calling in a security unless its coupon was so high that refinancing at today's rates offered a cost savings. My curiosity got the best of me so I contacted the author, Neil Shah or the Wall Street Journal.
Mr. Shah was happy to answer my e-mails, but what he told me made me concerned that those reporting on more esoteric securities have little understanding of their markets. The first thing I did was ask Mr. Shah to offer an example of a hybrid security which investors expected to be called. They security he used as an example as a Deutsche Bank 1,000 euro perpetual hybrid (yes, it is euro denominated), 3.875% due 2014. My eyes nearly popped out of my head. How could anyone in their right minds believe that a bank which would need to offer a five-year bond of at least 6.00%, if not higher, in today's environment call in a hybrid with a 3.875% coupon? Mr. Shah insists that investors expected this security and others like it to be called. My colleagues and I would be anxious to be the other side of these investors' trades. We could probably make a nice living this way, albeit for a short period of time as they would soon run out of capital. Mr. Shah also insisted that similar securities (with similar coupons) have been called in during the past year. Skeptical, we looked into this. We could not find an example. Mr. Shah couldn't or wouldn't offer examples. This myth was busted.
Today, Bloomberg News discussed hybrids. Although the securities discussed by Bloomberg are more closely related to the more familiar $25 trust preferreds, the article was about a different kind of structure.
The Bloomberg article discussed how hybrid securities may stop paying interest if a bank was nationalized. The securities being referred to are $1,000 trust securities. These are essentially trust preferreds which trade and look like corporate bonds. As with $25 trust preferreds, they are kinds of junior subordinate debt. The article is correct that in the case of a nationalization, hybrid interest payments could be stopped. They could be stopped permanently. They could be stopped temporarily. However, this could be true of straight preferreds (non-cumulative preferred equity), common shares and even senior debt.
In the case of a nationalization, the government could force what is known as a cram down. A cram down results in investors receiving less than par for their securities. The more senior one's securities are, the more one will receive. In the case of a cram down, investors have little recourse but to take what they get. Trust securities will always fair better than common and preferred equity and will always fair worse than more senior debt. The article was right to express concern over the treatment of trust securities in the case of a nationalization, but it should have mentioned that more subordinate securities are even more vulnerable.
The Bloomberg article, although not really false, appeared to foster a myth that hybrids were especially vulnerable to a nationalization. In actuality, non-cumulative preferred equity and common shares are even more vulnerable and even senior debt is may not be immune. The bottom line is that if one thinks that a true nationalization is possible for a bank, one should look elsewhere for investment opportunities. Although the nationalization of troubled banks is possible, it is an action of last resort as it would be expensive and cumbersome to seize a large bank. I would have to say that the myth that hybrids are an especially vulnerable asset class has been busted.
Sunday, February 1, 2009
Into The Great Wide Open
Benanke and Co. are not addressing the core problem. The core problem is not the GSE qualifying mortgages which the Fed is buying in securities form (along with GSE debt). It is the so-called jumbo mortgages (original balances over $417,000) which are problems. Many of these mortgages are for homes purchased at the peak of the bubble. They cannot be refinanced via a Freddie, Fannie or Ginnie mortgage. Banks are very careful about to whom they lend above the GSE limits because it is very difficult to securitize these mortgages because, unlike GSE MBS in which the investors' principal is guaranteed by the GSEs, a so-called private label MBS is backed ONLY by the underlying mortgages. If they fail, you fail.
There is a populist movement which wants the banks to hold mortgages so that they will have "skin in the game" like in the old days. This sounds good on Main Street, but by going this route, even responsible borrowers would not be able to obtain mortgages. Even the largest banks would soon run out of lending capital. If bank used corporate bonds of covered bonds (corporates backed by a pool of mortgages), these bonds would be counted as debt on corporate balance sheets. To maintain acceptable Tier-I Capital ratios, banks would need billions of deposits or equity or preferred IPOs. Not going to happen except from the government (I.E. the TARP preferreds).
Even with the banks "leveraged gone wild" period considered, the damage to the economy need not have gotten this severe. If home prices were permitted to adjust (fall) to levels based on supply and demand early in 2008, we may have seen a recovery by now. What happened instead were several half measures to keep people in homes who could not afford to keep them and a push to refinance mortgages with balances higher than the homes true worth (as opposed to bubble value). These half measures kept home buyers out of the market as the waited for home prices to fall, believing (correctly) that the government would only make things worse.
The result has been a long slow bleed of home prices. This long slow bleed has eroded consumer confidence, reduced consumer spending and has caused the broader, even global, economy to sputter and stall (decoupling my butt). This has removed more potential home buyers from the market. The reduced demand from fewer potential home buyers promises to push home prices even lower. Now we are in a negative feedback loop. Home prices continue to fall, consumer confidence falls. layoffs mount and more home owners, even those who acted responsibly, fall behind on their mortgage payments as they lose their jobs.
Are home prices artificially low? Not according to the data. In many markets home prices are only approaching the pre-bubble levels of 2004 (Bloomberg News). This looks like a correction to me. However, Main Street and the politicians who pander to it believe that home prices should be immune from price cycles. Sorry folks, homes are commodities just like anything else. Their prices rise and fall for a number of reasons. Any attempts to interfere with market forces will be more harmful than helpful.
A few weeks back I discussed LIBOR-based floaters. Some concerns I had with the strategy of purchasing such preferreds was that their mechanics (how they trade and why) and where LIBOR was going and why were not understood. One of my concerns was that the TED spreads (spread between three-month LIBOR and the Three-month T-Bill will would narrow by the three-month LIBOR rate falling. This is what happened. As of Friday January 30th, three month LIBOR was down to 1.18% The TED spread, although still wider than normal (normal is 20 to 30 basis points). Current spread is about 95 basis points. With the Fed stating last week that it is going to keep the Fed Funds rate at or near zero for an extended period of time, I expect the TED spread to continue to narrow by three-month LIBOR rates falling. After all, one of the Fed's goals, as stated last year after Bear Stearns imploded, was to improve interbank lending.
Some investors may be saying: "So what, these preferreds have coupon floors." Although that is correct, the deeper LIBOR sinks, the more of an upward move in short-term is needed to get off of that floor. Also, in theory, the deeper LIBOR sinks and the further below the floor the raw coupon calculation gets, the cheaper these floaters should trade. Even if they don't sink much more, they sure as heck shouldn't rise in value (unless of course, investors who don't understand floaters come in and buy). I would wait a bit longer before jumping in to the floaters. LIBOR should fall a bit more.
One other aspect of these LIBOR based floaters of which investors should be aware. They are all preferred equity and rank below all debt and are equal to the government's TARP preferreds on the capital structure. Of course unlike publicly-traded preferred stocks, the government gave itself a cumulative feature.
Some investors question the advantages of moving only one step higher on the capital structure, from a traditional preferred to a trust preferred. In reality it is more than one step.
As a trust preferred holder one is a creditor of said company. As very junior creditor, but a creditor nonetheless. As a preferred stock holder, you are a part owner of the company. The differences in investor classes can be distinguished in terms of a small business.
Let's say "Joe" owns a small business. Joe needs money so I invest in his firm to the tune of a 10% investment. I now own 10% of Joe's company. A few months later, Joe needs more money so he gets a loan from the bank. Later that year, Joe's company is barely breaking even. He has a choice to pay me a distribution (dividend) of make payments on his bank loan. Obviously the bank gets paid instead of me. The bank is a creditor and deserves to be paid regardless of profitability. I am a part owner, I should only be paid out of profits. This is the big difference.
There is a populist movement which wants the banks to hold mortgages so that they will have "skin in the game" like in the old days. This sounds good on Main Street, but by going this route, even responsible borrowers would not be able to obtain mortgages. Even the largest banks would soon run out of lending capital. If bank used corporate bonds of covered bonds (corporates backed by a pool of mortgages), these bonds would be counted as debt on corporate balance sheets. To maintain acceptable Tier-I Capital ratios, banks would need billions of deposits or equity or preferred IPOs. Not going to happen except from the government (I.E. the TARP preferreds).
Even with the banks "leveraged gone wild" period considered, the damage to the economy need not have gotten this severe. If home prices were permitted to adjust (fall) to levels based on supply and demand early in 2008, we may have seen a recovery by now. What happened instead were several half measures to keep people in homes who could not afford to keep them and a push to refinance mortgages with balances higher than the homes true worth (as opposed to bubble value). These half measures kept home buyers out of the market as the waited for home prices to fall, believing (correctly) that the government would only make things worse.
The result has been a long slow bleed of home prices. This long slow bleed has eroded consumer confidence, reduced consumer spending and has caused the broader, even global, economy to sputter and stall (decoupling my butt). This has removed more potential home buyers from the market. The reduced demand from fewer potential home buyers promises to push home prices even lower. Now we are in a negative feedback loop. Home prices continue to fall, consumer confidence falls. layoffs mount and more home owners, even those who acted responsibly, fall behind on their mortgage payments as they lose their jobs.
Are home prices artificially low? Not according to the data. In many markets home prices are only approaching the pre-bubble levels of 2004 (Bloomberg News). This looks like a correction to me. However, Main Street and the politicians who pander to it believe that home prices should be immune from price cycles. Sorry folks, homes are commodities just like anything else. Their prices rise and fall for a number of reasons. Any attempts to interfere with market forces will be more harmful than helpful.
A few weeks back I discussed LIBOR-based floaters. Some concerns I had with the strategy of purchasing such preferreds was that their mechanics (how they trade and why) and where LIBOR was going and why were not understood. One of my concerns was that the TED spreads (spread between three-month LIBOR and the Three-month T-Bill will would narrow by the three-month LIBOR rate falling. This is what happened. As of Friday January 30th, three month LIBOR was down to 1.18% The TED spread, although still wider than normal (normal is 20 to 30 basis points). Current spread is about 95 basis points. With the Fed stating last week that it is going to keep the Fed Funds rate at or near zero for an extended period of time, I expect the TED spread to continue to narrow by three-month LIBOR rates falling. After all, one of the Fed's goals, as stated last year after Bear Stearns imploded, was to improve interbank lending.
Some investors may be saying: "So what, these preferreds have coupon floors." Although that is correct, the deeper LIBOR sinks, the more of an upward move in short-term is needed to get off of that floor. Also, in theory, the deeper LIBOR sinks and the further below the floor the raw coupon calculation gets, the cheaper these floaters should trade. Even if they don't sink much more, they sure as heck shouldn't rise in value (unless of course, investors who don't understand floaters come in and buy). I would wait a bit longer before jumping in to the floaters. LIBOR should fall a bit more.
One other aspect of these LIBOR based floaters of which investors should be aware. They are all preferred equity and rank below all debt and are equal to the government's TARP preferreds on the capital structure. Of course unlike publicly-traded preferred stocks, the government gave itself a cumulative feature.
Some investors question the advantages of moving only one step higher on the capital structure, from a traditional preferred to a trust preferred. In reality it is more than one step.
As a trust preferred holder one is a creditor of said company. As very junior creditor, but a creditor nonetheless. As a preferred stock holder, you are a part owner of the company. The differences in investor classes can be distinguished in terms of a small business.
Let's say "Joe" owns a small business. Joe needs money so I invest in his firm to the tune of a 10% investment. I now own 10% of Joe's company. A few months later, Joe needs more money so he gets a loan from the bank. Later that year, Joe's company is barely breaking even. He has a choice to pay me a distribution (dividend) of make payments on his bank loan. Obviously the bank gets paid instead of me. The bank is a creditor and deserves to be paid regardless of profitability. I am a part owner, I should only be paid out of profits. This is the big difference.
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