Some people call me the space cowboy, yeah
Some call me the gangster of love ~ Steve Miller
GM announced its equity for debt swap and it is a joke. As per GM's S-4 filing, GM Bondholders would receive approximately 45 cents on the dollar, all in common equity. Although this may appear generous to those who were fearing news reports of 10 to 20 cents on the dollar could be reality, but if it appears that these terms are generous, the joke is on you.
Although 45 cents may appear relatively attractive, agreeing to such an exchange would leave bondholders in a bad situation. As the result of such an exchange bondholders would own 10 percent of GM. However, the UAW owns 30 percent and its government masters (or enablers) would own 50 percent. Gee, in whose interest do you think GM would be run?
Former Labor Secretary Robert Reich made it very clear in Saturday's Wall Street Journal when he stated:
"Suppose we tell General Motors Corp. -- now partly ours -- to shift its fleet to more fuel-efficient cars. Yet its executives know that as long as gas prices are low, Americans remain infatuated with highly profitable SUVs and pickup trucks? GM executives would have a perfect right, if not a duty, to disregard what we as citizens tell them to do in favor of what shareholders want them to do."
So let's get this straight. The government will exercise its authority as controlling shareholder to do what "citizens" want, not what the other shareholders want? The other shareholders want to build cares that consumers (citizens) will buy. Mr. Reich appears to be confused. He is far from confused. His "citizens" are not traditional automobile buyers, but the green lobby and other liberal groups. Trust me, if comsumers demand hybrids, electric cars or micro-cars, Detroit will build them, unless they would be unprofitable given their labor agreements. Here comes the punchline to this very bad joke.
A government-run GM would be run like a government program. It would provide jobs and build vehicles its political masters, not consumers demand. Any revenue shortfalls would be picked up by the government through tax dollars. Think of this as another WPA. Cars will be built purely to provide jobs. The types of vehicles will be chosen to appease liberal political supporters. Why would bondholders agree to this?
The simple answer is they won't. Bloomberg News is reporting that an ad hoc group of GM bondholders (the steering committee) is calling the proposal "unreasonable". Shelly Lombard, an analyst an Gimme Credit believes that bondholders could do worse in bankruptcy court. It is not certain that bondholders would receive any more in the way of numeric compensation, but bankruptcy could have some advantages for bondholders.
First, the bondholders would have a realistic chance of restructuring UAW agreements to reflect some semblance of reality. Secondly, the may receive compensation other than common equity. Maybe bondholders would receive new debt as partial compensation giving them a higher claim than the UAW or he government. Thirdly, by forcing GM into bankruptcy, shares issued to creditors would be new shares as existing shareholders (including the UAW and government) wiped out. This last point is the real reason the government and UAW want to avoid bankruptcy. Sorry Shelly ol' gal, That last point was an easy one.
Look for the bondholders to push for a bankruptcy and for Steve Rattner and Ron Gettelfinger to soil their undergarments.
Monday, April 27, 2009
Wednesday, April 22, 2009
On The Road Again
I was on the road today so I am not in my usual form. However, I need to discuss Morgan Stanley. Morgan Stanley reported disappointed earning versus analyst estimates. Reasons for the disappointing earnings were reduced leverage and risk taking by the Firm's fixed income traders and the marking up of Morgan Stanley bond values.
The current financial crisis was caused by poor (or derelict) risk management. However, most firms (JPM, GS and BAC) did not abandon the fixed income trading arena. According to the earnings report, Morgan Stanley reduced its leverage to 11 time. Has Morgan Stanley gone too far? Possibly, especially considering that it is a BINO (bank in name only) and does not have the diverse income sources of the larger financial institutions. Historically, investment banks have taken more leverage than money center banks. However, Morgan Stanley is a TARP institution and management may have felt that it should not take in too much risk. How much risk and leverage is enough? That is something which will be debated for years to come. I think it is safe to say that we will not see Bear and Lehman levels of 25 to 30 times anytime soon..
Another reason for Morgan's disappointing earnings was that it had to mark its debt up. One would think that one's bonds trading at higher prices would be a good thing. After all, higher prices equal lower yields and therefore, lower borrowing costs. However, there is accounting trickery afoot. As demonstrated by another large bank which reported earnings last week, how one marks one's bonds can lead to profits or losses.
Last week, a large bank which doesn't sleep recorded unrealized profits by marking down (accurately) the value of its outstanding bonds. The accounting theory is that as company can retire its debt below par by purchasing its bonds in the open market. The problem is that when a company's bonds trade at a deep discount it is because its in poor financial condition and not able to retire debt. Morgan Stanley was on the other side of this coin. Last quarter, MS took advantage of accounting rules and marked down the value of its bonds, but as spreads tightened and treasury benchmarks remained low, MS was forced to mark its bond prices higher, giving up unrealized profits. Live by clever accounting, die by clever accounting.
Late in the day, GM announced that it will not be paying of $1 billion of bonds coming due on 6/1/09. Instead it is hoping to cut a deal with creditors which will allow the company to give investors cents on the dollar in the form of equity shares. It will be interesting to see how creditors react to what amounts to a technical default. If bondholders do not agree to a deal with GM, they could force an involuntary bankruptcy. Stay tuned.
The current financial crisis was caused by poor (or derelict) risk management. However, most firms (JPM, GS and BAC) did not abandon the fixed income trading arena. According to the earnings report, Morgan Stanley reduced its leverage to 11 time. Has Morgan Stanley gone too far? Possibly, especially considering that it is a BINO (bank in name only) and does not have the diverse income sources of the larger financial institutions. Historically, investment banks have taken more leverage than money center banks. However, Morgan Stanley is a TARP institution and management may have felt that it should not take in too much risk. How much risk and leverage is enough? That is something which will be debated for years to come. I think it is safe to say that we will not see Bear and Lehman levels of 25 to 30 times anytime soon..
Another reason for Morgan's disappointing earnings was that it had to mark its debt up. One would think that one's bonds trading at higher prices would be a good thing. After all, higher prices equal lower yields and therefore, lower borrowing costs. However, there is accounting trickery afoot. As demonstrated by another large bank which reported earnings last week, how one marks one's bonds can lead to profits or losses.
Last week, a large bank which doesn't sleep recorded unrealized profits by marking down (accurately) the value of its outstanding bonds. The accounting theory is that as company can retire its debt below par by purchasing its bonds in the open market. The problem is that when a company's bonds trade at a deep discount it is because its in poor financial condition and not able to retire debt. Morgan Stanley was on the other side of this coin. Last quarter, MS took advantage of accounting rules and marked down the value of its bonds, but as spreads tightened and treasury benchmarks remained low, MS was forced to mark its bond prices higher, giving up unrealized profits. Live by clever accounting, die by clever accounting.
Late in the day, GM announced that it will not be paying of $1 billion of bonds coming due on 6/1/09. Instead it is hoping to cut a deal with creditors which will allow the company to give investors cents on the dollar in the form of equity shares. It will be interesting to see how creditors react to what amounts to a technical default. If bondholders do not agree to a deal with GM, they could force an involuntary bankruptcy. Stay tuned.
Tuesday, April 21, 2009
Strange Days Indeed
Nobody told me there'd be days like these
Nobody told me there'd be days like these
Nobody told me there'd be days like these
Strange days indeed -- strange days indeed ~ John Lennon
The Fed came in and bought $7 billion worth of U.S. treasuries causing prices of U.S. treasuries to decline. You can stop re-reading or rubbing your eyes. What I have just written is not a mistake. In the markets perception is everything. In this case, government bond traders were betting that the Fed would be more aggressive. True to its word, the Fed stayed within the 7-10 year range of the yield curve. This caused a healthy selloff of nearly a point. Rates on the long end of the curve could be stuck around current levels for a while as the countervailing forces of Fed purchases (it has bought on the long end before) and copious amounts of government debt issuance and dollar printing exert their effects. I still like JPM, GS, USB, PNC and GE Cap bonds as far out as 10-years. Eventual credit spread tightening could (should) make up for much of the effects of higher treasury benchmark yields.
President Obama's Automotive Task Force has decided to meet with GM bondholders. Thus far, GM bondholders have been excluded from government / GM discussions. This is a good idea if the Obama administration seeks to avoid a GM trip to bankruptcy court. However, this is just what bondholders may want.
Last week, GM announced that it will make an all equity settlement offer to GM bondholders. Speculation on the Street puts the compensation level at between 10 and 20 cents on the dollar. GM bondholders were not happy. A group of GM bondholders (who have become the defacto negotiators) had suggested a settlement of 33 cents on the dollar consisting of stock, bonds and cash. GM is insisting on all stock. Bondholders may be crazy, but they are not dumb. They know that owning stock in a suspect GM with a recalcitrant UAW is not an optimal situation. They also know that they would be in the best position of all parties in terms of compensation. The Obama Administration knows that the UAW would be at a severe disadvantage and the Administration doesn't want that. GM bondholders who want all cash should probably sell here. Those who want a chance at a higher return, but are not as concerned with how they are compensated, may want to hold and see how it all plays out.
Investors should note that GMAC bonds and bondholders are not involved with this process. GMAC has (and has always had) a separate capital structure. GMAC is not part of these negotiations. The government is very much incentivized to keep GMAC functioning (out of bankruptcy) if GM is to survive.
Here are the facts:
GMAC is a TARP bank holding company.
GMAC has (with government approval) the ability to issue TLGP bonds guaranteed by the FDIC.
GMAC is responsible for most (upwards of 90% by some accounts) of dealer inventory financing. No dealers = no GM = no UAW.
Although I cannot guarantee it (especially with the UAW involved with GM), GMAC bonds should be ok in the near future (2009 and maybe 2010). After that it is anyone's guess as GM's survival may not be so politically important in the future.
Citi conducted its annual shareholder meeting. Many investors vented their frustrations. Management was somewhat more humble, but the dysfunction continues.
The DJIA rallied after Tim (my story is ever-changing) Geithner stated that the "vast majority" of U.S. banks are well-capitalized. He is probably accurate when small local banks are included. However, some larger banks are only well capitalized because of government programs. Others (some quite large) are probably not well capitalized even with government liquidity programs. Thus far the government's TALF and PPIP plans have not been able to attract private investors, although retail brokers continue to call my place of employment stating that they have clients ready to invest. These investors should look around and see what institutions are investing along side them. They will discover that TALF and PPIP are lonely places.
Meanwhile bank CDS continues to trade at wide levels. The more suspect the bank, the wider the CDS spread. The bank vigilantes want to know the extent of the toxic assets on bank balance sheets and the want to know the damage and when they will be removed from bank balance sheets before the invest their capital in most, if not all banks. Oh yeah, whatever happened to the expected benefits of the change to mark to market accounting?
Until next time, stay safe in the markets. Not much makes sense these days.
Nobody told me there'd be days like these
Nobody told me there'd be days like these
Strange days indeed -- strange days indeed ~ John Lennon
The Fed came in and bought $7 billion worth of U.S. treasuries causing prices of U.S. treasuries to decline. You can stop re-reading or rubbing your eyes. What I have just written is not a mistake. In the markets perception is everything. In this case, government bond traders were betting that the Fed would be more aggressive. True to its word, the Fed stayed within the 7-10 year range of the yield curve. This caused a healthy selloff of nearly a point. Rates on the long end of the curve could be stuck around current levels for a while as the countervailing forces of Fed purchases (it has bought on the long end before) and copious amounts of government debt issuance and dollar printing exert their effects. I still like JPM, GS, USB, PNC and GE Cap bonds as far out as 10-years. Eventual credit spread tightening could (should) make up for much of the effects of higher treasury benchmark yields.
President Obama's Automotive Task Force has decided to meet with GM bondholders. Thus far, GM bondholders have been excluded from government / GM discussions. This is a good idea if the Obama administration seeks to avoid a GM trip to bankruptcy court. However, this is just what bondholders may want.
Last week, GM announced that it will make an all equity settlement offer to GM bondholders. Speculation on the Street puts the compensation level at between 10 and 20 cents on the dollar. GM bondholders were not happy. A group of GM bondholders (who have become the defacto negotiators) had suggested a settlement of 33 cents on the dollar consisting of stock, bonds and cash. GM is insisting on all stock. Bondholders may be crazy, but they are not dumb. They know that owning stock in a suspect GM with a recalcitrant UAW is not an optimal situation. They also know that they would be in the best position of all parties in terms of compensation. The Obama Administration knows that the UAW would be at a severe disadvantage and the Administration doesn't want that. GM bondholders who want all cash should probably sell here. Those who want a chance at a higher return, but are not as concerned with how they are compensated, may want to hold and see how it all plays out.
Investors should note that GMAC bonds and bondholders are not involved with this process. GMAC has (and has always had) a separate capital structure. GMAC is not part of these negotiations. The government is very much incentivized to keep GMAC functioning (out of bankruptcy) if GM is to survive.
Here are the facts:
GMAC is a TARP bank holding company.
GMAC has (with government approval) the ability to issue TLGP bonds guaranteed by the FDIC.
GMAC is responsible for most (upwards of 90% by some accounts) of dealer inventory financing. No dealers = no GM = no UAW.
Although I cannot guarantee it (especially with the UAW involved with GM), GMAC bonds should be ok in the near future (2009 and maybe 2010). After that it is anyone's guess as GM's survival may not be so politically important in the future.
Citi conducted its annual shareholder meeting. Many investors vented their frustrations. Management was somewhat more humble, but the dysfunction continues.
The DJIA rallied after Tim (my story is ever-changing) Geithner stated that the "vast majority" of U.S. banks are well-capitalized. He is probably accurate when small local banks are included. However, some larger banks are only well capitalized because of government programs. Others (some quite large) are probably not well capitalized even with government liquidity programs. Thus far the government's TALF and PPIP plans have not been able to attract private investors, although retail brokers continue to call my place of employment stating that they have clients ready to invest. These investors should look around and see what institutions are investing along side them. They will discover that TALF and PPIP are lonely places.
Meanwhile bank CDS continues to trade at wide levels. The more suspect the bank, the wider the CDS spread. The bank vigilantes want to know the extent of the toxic assets on bank balance sheets and the want to know the damage and when they will be removed from bank balance sheets before the invest their capital in most, if not all banks. Oh yeah, whatever happened to the expected benefits of the change to mark to market accounting?
Until next time, stay safe in the markets. Not much makes sense these days.
Monday, April 20, 2009
All I Can Do is Write About It
And Lord I can't make any changes
All I can do is write 'em in a song
I can see the concrete slowly creepin'
Lord take me and mine before that comes
'Cause I can see the concrete slowly creepin'
Lord take me and mine before that comes ~ Lynyrd Skynyrd
Bank of America reports earning which where three times higher and blew away analyst estimates. Share prices then proceeded to fall 24%. BAC reported gains from mortgage refinancing at its Countrywide unit and trading profits at its Merrill Lynch unit. However, loan losses and grim employment prospects caused market participants to send share and bond prices lower.
Notice it is loan losses, loans which are not marked to market, which are the problem. As with Citi, a significant portion of BAC's strong data may be due to accounting chicanery, I mean rules. I am still waiting to read analysts assessments, but I am interested to see if BAC pulled a Citi and booked its depressed bond prices as unrealized profits.
This is actually legal and acceptable by GAAP standards, but in my opinion it is unethical. They thinking is that if a company's bonds are trading at a significant discount the company will be able to purchase its bonds at a discount, thereby effectively retiring its debt below par. The problem with this is that the one reason a company's bonds would be trading at a significant discount is because the company has a weak credit profile. In other words it does not have the ready cash to pay back its debt early, even at deep discounts. Banks who book depressed bond prices as profits and then brag about their latest quarterly earnings are being disingenuous at best and committing permissible fraud at worst.
The real stories will be the stress test results. If these tests report that most large banks are just fine and need little or no further assistance, the markets will batter that banks. The market knows better. This has government officials quaking in their boots. They fear more bank runs. I wonder how those who were claiming that the change to MTM accounting rules would solve everything?
I wish I was still actively running a book. I would be like a kid in a candy store. All I can do is write about it. You can take the boy from trading, but you can't take trading from the boy.
All I can do is write 'em in a song
I can see the concrete slowly creepin'
Lord take me and mine before that comes
'Cause I can see the concrete slowly creepin'
Lord take me and mine before that comes ~ Lynyrd Skynyrd
Bank of America reports earning which where three times higher and blew away analyst estimates. Share prices then proceeded to fall 24%. BAC reported gains from mortgage refinancing at its Countrywide unit and trading profits at its Merrill Lynch unit. However, loan losses and grim employment prospects caused market participants to send share and bond prices lower.
Notice it is loan losses, loans which are not marked to market, which are the problem. As with Citi, a significant portion of BAC's strong data may be due to accounting chicanery, I mean rules. I am still waiting to read analysts assessments, but I am interested to see if BAC pulled a Citi and booked its depressed bond prices as unrealized profits.
This is actually legal and acceptable by GAAP standards, but in my opinion it is unethical. They thinking is that if a company's bonds are trading at a significant discount the company will be able to purchase its bonds at a discount, thereby effectively retiring its debt below par. The problem with this is that the one reason a company's bonds would be trading at a significant discount is because the company has a weak credit profile. In other words it does not have the ready cash to pay back its debt early, even at deep discounts. Banks who book depressed bond prices as profits and then brag about their latest quarterly earnings are being disingenuous at best and committing permissible fraud at worst.
The real stories will be the stress test results. If these tests report that most large banks are just fine and need little or no further assistance, the markets will batter that banks. The market knows better. This has government officials quaking in their boots. They fear more bank runs. I wonder how those who were claiming that the change to MTM accounting rules would solve everything?
I wish I was still actively running a book. I would be like a kid in a candy store. All I can do is write about it. You can take the boy from trading, but you can't take trading from the boy.
Sunday, April 19, 2009
Already Gone
Well I heard some people talkin' just the other day
And they said you were gonna put me on a shelf
But let me tell you I got some news for you
And you'll soon find out it's true
And then you'll have to eat your lunch all by yourself
'Cause I'm already gone
And I'm feelin' strong
I will sing this vict'ry song woo hoo hoo woo hoo hoo
-The Eagles
Now that my primary career is likely winding down, I will open things up a bit. This weekend in the Wall Street Journal and in Barron's the quality of bank earnings is discussed. Nothing which is discussed should surprise anyone who has read this publication or paid attention to the fixed income markets. While the equity market and the stock jockeys (and their CNBC instigators) pushed for and then celebrated the modification of mark to market accounting, fixed income market participants knew the real story. They knew where much of first quarter profits were created and what challenges lay ahead for financial institutions.
Many readers have called me on the desk asking my opinion of statements made by certain bank CEOs that January and February were profitable. It pained be to rain on the parades of optimistic and hopeful advisers and investors, but I had to point out that AIG was responsible for fast starts by banks in 2009. AIG was being pushed by its government masters to unwind counterparty agreements and insurance contracts immediately. AIG paid up to do so. This created profits for troubled banks. These profits appeared as profits from capital markets and trading. It is true that financial firms' did earn some impressive profits from trading and underwriting, but AIG had much to do with the good first quarters we are seeing.
Some banks were less transparent than others. One large bank which reported earning last week was downright boastful. Its CEO was bragging how its capital markets division outperformed JP Morgan and Goldman Sachs. This is like the owner of the Kansas City Royals bragging that his team got off to a better start than the Yankees and the Red Sox without acknowledging that his team was the beneficiary of playing week, pitching-deficient opponents. A wise owner would be wise not to compare his team with the leagues elite when it is playing with a thin bench and an over-worked bullpen (as is the aforementioned large bank). Maybe this CEO should explain why his soon-to-be shared wealth management unit was reported by Bloomberg News to have lost $40 billion in client assets which have deserted the bank for other firms. My colleagues and I did some estimating of our own and believe that the figure could be upward of $50 billion. This does not count the loss of some big producing teams which we learned are leaving the firm as of last Friday.
The Barron's article correctly states that it is the Temporary Liquidity Guarantee Program (TLGP) which is the real boon to the banks rather than TARP. The TLGP program enables banks (and banks in name only) to issue bonds with the EXPLICIT guarantee of the U.S. government. This is a stronger guarantee than what is carried by FHLMC and FNMA bonds which are only "effectively" according to FHFA Chairman Lockhart (an effective guarantee is merely an acknowledgement of the implied guarantee which has existed all along). Although provisions were put in place to address the repayment of TARP money, the government never thought (yeah, that's surprising) to address the TLGP bonds. As of now, companies such as JPM (which has the funds) and Goldman Sachs (which has nearly enough funds) can pay back TARP money. However, both companies have issued TLGP bonds with coupons in the low 2.00% area or less. The government was banking on (no pun intended) that banks would be unable or unwilling to pay back TARP funds early. Therefore, the government never thought it would have to address the problem of banks exiting the TARP program yet continuing to benefit from TLGP. In fact, as of right now banks can leave TARP but continue to issue FDIC-guaranteed bonds with maturities as long as December 2012. FDIC chief Sheila Bair had been advocating extending the maximum maturity until 2019. Now word on how she likes her crow prepared ( au vin would be my choice).
The large bank which as been the subject of much media attention since Friday has been criticized for skimping on loan loss reserves. This is not a matter which should be taken lightly (by any bank for that matter). All the data indicates that defaults and delinquencies among mortgages, credit cards, auto loans and lines of credit continue to rise. While the bulls and broker cheerleaders (also known as management) continue to predict a quick economic recovery and push FAs to allocate more client assets to equities, some of us are focused on rising unemployment and its lagging effects. What lagging effects? When workers lose their jobs, they do not always immediately fall behind in their payments. Some have severance pay and nearly all have unemployment benefits. We probably have not seen the full effects of the sharp increase of unemployment in loan defaults and delinquencies. This makes the stress tests very important, if they are not charades or shams.
Properly conducted, the stress tests would reveal the true values of assets held on bank balance sheets, including loans. Loans could be the critical asset class as they are not now, nor have they ever been, subject to mark to market accounting. There could be hidden land mines among the banks. Some have been more transparent than others. Last week, JP Morgan's earnings report included loan writedowns of $700M. Although this may not represent the true extent of balance sheet impairment, the company at least partially acknowledged its problems. No such writedowns were taken by the other, chest-pounding, bank which reported earnings last week. Want to see which banks are relatively healthy and which banks are not. The healthy banks are planning to pay back TARP early. The unhealthy banks boast while they are forced to sell of businesses at the behest of the government.
And they said you were gonna put me on a shelf
But let me tell you I got some news for you
And you'll soon find out it's true
And then you'll have to eat your lunch all by yourself
'Cause I'm already gone
And I'm feelin' strong
I will sing this vict'ry song woo hoo hoo woo hoo hoo
-The Eagles
Now that my primary career is likely winding down, I will open things up a bit. This weekend in the Wall Street Journal and in Barron's the quality of bank earnings is discussed. Nothing which is discussed should surprise anyone who has read this publication or paid attention to the fixed income markets. While the equity market and the stock jockeys (and their CNBC instigators) pushed for and then celebrated the modification of mark to market accounting, fixed income market participants knew the real story. They knew where much of first quarter profits were created and what challenges lay ahead for financial institutions.
Many readers have called me on the desk asking my opinion of statements made by certain bank CEOs that January and February were profitable. It pained be to rain on the parades of optimistic and hopeful advisers and investors, but I had to point out that AIG was responsible for fast starts by banks in 2009. AIG was being pushed by its government masters to unwind counterparty agreements and insurance contracts immediately. AIG paid up to do so. This created profits for troubled banks. These profits appeared as profits from capital markets and trading. It is true that financial firms' did earn some impressive profits from trading and underwriting, but AIG had much to do with the good first quarters we are seeing.
Some banks were less transparent than others. One large bank which reported earning last week was downright boastful. Its CEO was bragging how its capital markets division outperformed JP Morgan and Goldman Sachs. This is like the owner of the Kansas City Royals bragging that his team got off to a better start than the Yankees and the Red Sox without acknowledging that his team was the beneficiary of playing week, pitching-deficient opponents. A wise owner would be wise not to compare his team with the leagues elite when it is playing with a thin bench and an over-worked bullpen (as is the aforementioned large bank). Maybe this CEO should explain why his soon-to-be shared wealth management unit was reported by Bloomberg News to have lost $40 billion in client assets which have deserted the bank for other firms. My colleagues and I did some estimating of our own and believe that the figure could be upward of $50 billion. This does not count the loss of some big producing teams which we learned are leaving the firm as of last Friday.
The Barron's article correctly states that it is the Temporary Liquidity Guarantee Program (TLGP) which is the real boon to the banks rather than TARP. The TLGP program enables banks (and banks in name only) to issue bonds with the EXPLICIT guarantee of the U.S. government. This is a stronger guarantee than what is carried by FHLMC and FNMA bonds which are only "effectively" according to FHFA Chairman Lockhart (an effective guarantee is merely an acknowledgement of the implied guarantee which has existed all along). Although provisions were put in place to address the repayment of TARP money, the government never thought (yeah, that's surprising) to address the TLGP bonds. As of now, companies such as JPM (which has the funds) and Goldman Sachs (which has nearly enough funds) can pay back TARP money. However, both companies have issued TLGP bonds with coupons in the low 2.00% area or less. The government was banking on (no pun intended) that banks would be unable or unwilling to pay back TARP funds early. Therefore, the government never thought it would have to address the problem of banks exiting the TARP program yet continuing to benefit from TLGP. In fact, as of right now banks can leave TARP but continue to issue FDIC-guaranteed bonds with maturities as long as December 2012. FDIC chief Sheila Bair had been advocating extending the maximum maturity until 2019. Now word on how she likes her crow prepared ( au vin would be my choice).
The large bank which as been the subject of much media attention since Friday has been criticized for skimping on loan loss reserves. This is not a matter which should be taken lightly (by any bank for that matter). All the data indicates that defaults and delinquencies among mortgages, credit cards, auto loans and lines of credit continue to rise. While the bulls and broker cheerleaders (also known as management) continue to predict a quick economic recovery and push FAs to allocate more client assets to equities, some of us are focused on rising unemployment and its lagging effects. What lagging effects? When workers lose their jobs, they do not always immediately fall behind in their payments. Some have severance pay and nearly all have unemployment benefits. We probably have not seen the full effects of the sharp increase of unemployment in loan defaults and delinquencies. This makes the stress tests very important, if they are not charades or shams.
Properly conducted, the stress tests would reveal the true values of assets held on bank balance sheets, including loans. Loans could be the critical asset class as they are not now, nor have they ever been, subject to mark to market accounting. There could be hidden land mines among the banks. Some have been more transparent than others. Last week, JP Morgan's earnings report included loan writedowns of $700M. Although this may not represent the true extent of balance sheet impairment, the company at least partially acknowledged its problems. No such writedowns were taken by the other, chest-pounding, bank which reported earnings last week. Want to see which banks are relatively healthy and which banks are not. The healthy banks are planning to pay back TARP early. The unhealthy banks boast while they are forced to sell of businesses at the behest of the government.
Tuesday, April 14, 2009
Dazed and Confused
The trading situations of C preferreds and C common have generated many questions among readers, colleagues and financial advisers. Unfortunately, some in the financial press wouldn't know the causes of a technical trade situation from their hind quarters. Let's clear the air.
First Barron's reported over the weekend that the discount between the trading levels of C common and C straight preferreds (CprP and CprM) was due to a short squeeze and that the preferred prices would rally to close the gap as the preferred shares trade at parity to the exchange. Hold on there. Someone doesn't understand trading.
Although it is true that there is a short squeeze happening with regards to C common, it is deal uncertainty which is causing the dramatic discount versus parity of the trading levels of C common and C preferreds. This is not uncommon. When securities are called or a tender offer is announced trading prices are usually at a discount versus the prices announced in the terms of the deal. This is because that until a deal is done terms can change or the deal can be cancelled. To take on this uncertainty (deal risk), investors (speculators) seek to pay a discount to the final or proposed final price. For this reason it is unlikely for C preferred shares to trade at exchange parity with C common until the deal is done (assuming that the terms of the deal do not change). A Bank of America analyst is speculating that the terms do change. I have no idea if he will be proven correct, but for most income-oriented investors it makes no difference, owning CprP and CprM is not appropriate. Those who choose to time a technically-driven market deserve any pain they experience.
The Wall Street Journal, which has its moments (good and bad) correctly states why C common shares are rallying. The Journal states: Citigroup Inc. stock's upward momentum may continue longer than some market professionals are expecting -- and it isn't because investors have suddenly regained faith in the banking company's prospects.
Instead, Citigroup's plans to issue billions of new shares won't move forward until at least Friday, potentially prolonging a "short squeeze" that has been inflating the company's shares.
Again, as long as the deal happens in some form the dividends on CprP and CprM will be permanently eliminated. Now is not the time to wring every last cent out of the preferred shares. Now is the time to move on to new investments while there is a healthy bid for C preferreds. This will not last forever. It is very possible, if not probable, that common share prices will fall to parity with preferred shares once the short squeeze is over. Also, once the deal is done and the preferred dividends are gone for good and the shares delisted, bids will be quoted in pennies.
One last thing. Any questions regarding this publication should be directed back to this e-mail address. This includes requests to be added to the list.
First Barron's reported over the weekend that the discount between the trading levels of C common and C straight preferreds (CprP and CprM) was due to a short squeeze and that the preferred prices would rally to close the gap as the preferred shares trade at parity to the exchange. Hold on there. Someone doesn't understand trading.
Although it is true that there is a short squeeze happening with regards to C common, it is deal uncertainty which is causing the dramatic discount versus parity of the trading levels of C common and C preferreds. This is not uncommon. When securities are called or a tender offer is announced trading prices are usually at a discount versus the prices announced in the terms of the deal. This is because that until a deal is done terms can change or the deal can be cancelled. To take on this uncertainty (deal risk), investors (speculators) seek to pay a discount to the final or proposed final price. For this reason it is unlikely for C preferred shares to trade at exchange parity with C common until the deal is done (assuming that the terms of the deal do not change). A Bank of America analyst is speculating that the terms do change. I have no idea if he will be proven correct, but for most income-oriented investors it makes no difference, owning CprP and CprM is not appropriate. Those who choose to time a technically-driven market deserve any pain they experience.
The Wall Street Journal, which has its moments (good and bad) correctly states why C common shares are rallying. The Journal states: Citigroup Inc. stock's upward momentum may continue longer than some market professionals are expecting -- and it isn't because investors have suddenly regained faith in the banking company's prospects.
Instead, Citigroup's plans to issue billions of new shares won't move forward until at least Friday, potentially prolonging a "short squeeze" that has been inflating the company's shares.
Again, as long as the deal happens in some form the dividends on CprP and CprM will be permanently eliminated. Now is not the time to wring every last cent out of the preferred shares. Now is the time to move on to new investments while there is a healthy bid for C preferreds. This will not last forever. It is very possible, if not probable, that common share prices will fall to parity with preferred shares once the short squeeze is over. Also, once the deal is done and the preferred dividends are gone for good and the shares delisted, bids will be quoted in pennies.
One last thing. Any questions regarding this publication should be directed back to this e-mail address. This includes requests to be added to the list.
Monday, April 6, 2009
Give Me Hams, Hold the Mayo
The rebuke of the FASB decision to modify MTM accounting rules continues. The latest analyst to bash the banks since the FASB decision is Mr. Mike Mayo of Calyon Securities. Mr. Mayo advised investors to sell bank stocks. He rates banks such as KeyCorp, Fifth Third, BB&T, SunTrust and U.S. Bancorp as "sells". He gave "underperform" ratings to BAC, C, JPM, PNC, and Comerica. Mr. Mayo expressed concern over rising loan losses.
This is not surprising. Loans are not marked to market but will probably be valued as part of the upcoming "Stress Tests". The government may "strongly suggest" that banks sell certain loans at prices below where they are valued on banks balance sheets. The government would then inject more capital into the bank, possibly in the form of convertible preferreds which can be exchanged, at the behest of the banks, into common equity (to improve TCE vs. total assets). This could dilute share prices.
Things are much rosier on the bond side. Although bank corporate bonds have not rallied along with common shares, the do not pose the same kind of volatility risk. Senior note holders of the major banks, including those on Mr, Mayo's sell and underperform lists, probably have little to fear in the way of defaults. Movements in bond spreads have been muted in either direction. Yes it is true that bank CDS continues to widen, but there is probably a technical reason for this. Hedge fund and other money managers may be purchasing CDS protection as an alternative to shorting the common. Bad news from a bank would benefit one who is short the common and one who purchased protection. Therefore, those who are offering protection want a larger premium to do do.
Look to senior bank paper as a way to pick up yield with minimal default risk.
This is not surprising. Loans are not marked to market but will probably be valued as part of the upcoming "Stress Tests". The government may "strongly suggest" that banks sell certain loans at prices below where they are valued on banks balance sheets. The government would then inject more capital into the bank, possibly in the form of convertible preferreds which can be exchanged, at the behest of the banks, into common equity (to improve TCE vs. total assets). This could dilute share prices.
Things are much rosier on the bond side. Although bank corporate bonds have not rallied along with common shares, the do not pose the same kind of volatility risk. Senior note holders of the major banks, including those on Mr, Mayo's sell and underperform lists, probably have little to fear in the way of defaults. Movements in bond spreads have been muted in either direction. Yes it is true that bank CDS continues to widen, but there is probably a technical reason for this. Hedge fund and other money managers may be purchasing CDS protection as an alternative to shorting the common. Bad news from a bank would benefit one who is short the common and one who purchased protection. Therefore, those who are offering protection want a larger premium to do do.
Look to senior bank paper as a way to pick up yield with minimal default risk.
Saturday, April 4, 2009
Goldman Years
In my last report, I opined that Wall Street analysts (many of whom are CFA charter holders (The CFA Institute was against the MTM changes)) would not view the FASB's changes to MTM accounting favorably. Goldman analyst Richard Ramsden published in a report: "Our core view is that banks will not bottom until underperforming asset growth decelerates." He continues: "Loans are going bad faster than banks earn money."
This is not dissimilar from what I have written in the past. Research reports from around Wall Street indicate that only 70% of toxic assets were subject to mark to market to begin with. The effects of record or near record layoffs have not been fully accounted for in mortgage delinquencies and defaults. There is usually a lag as unemployment benefits and severance funds run out. If the stress test is an honest assessment of the banks, we could very well see more capital injections into the most troubled banks.
This is not dissimilar from what I have written in the past. Research reports from around Wall Street indicate that only 70% of toxic assets were subject to mark to market to begin with. The effects of record or near record layoffs have not been fully accounted for in mortgage delinquencies and defaults. There is usually a lag as unemployment benefits and severance funds run out. If the stress test is an honest assessment of the banks, we could very well see more capital injections into the most troubled banks.
Thursday, April 2, 2009
Twist and Shout
On the way to the hospital this evening (my other half twisted her knee playing racquet ball. She is ok), I was listening to Kudlow & Co. on Sirius Radio (I am long that dog of a stock). The program turned to a discussion on today's FASB decision to modify mark to market accounting. As expected Larry and his pal Steve Forbes extolled the virtues of modifying MTM as it would permit banks to value their assets based on cash flows instead of being subject to the vagaries of the market. Making a valid defense of transparency was Jim Glassman (President, World Growth Institute and former Undersecretary of State).
Mr. Glassman expressed concerns that the markets could be come concerned that banks may over value toxic assets and could be encouraged to take more risks. Mr. Glassman is not alone. The CFA Institute (members of which make up the majority of securities analysts) also has spoken out against modifying or eliminating mark to market.
Mr. Glassman was in the midst of a valiant defense of MTM when Kudlow and Forbes began twisting. They both began harping that banks usually hold loans until maturity and that they should not be marked to market. They then cut off Mr. Glassman. The twist was not in Mr. Kudlow's and Mr. Forbes' argument that banks usually hold loans to maturity (although that is not always the case), but rather because banks often do hold loans to maturity, they WERE NEVER REQUIRED TO MARK LOANS TO MARKET. Here lies the rub.
Modifying MTM permits banks to now not mark securities to market if the bank believes the market price does not reflect the true value of the security. What a great idea. I wish I had that ability when I was trading. Will others be permitted to do this as well? We have all tried to get bids for illiquid securities that we or are clients own. Sometimes, because of illiquidity, market bid prices are low. One can even see this in securities such as GMAC Smartnotes. Because of illiquidity, GMAC Smartnotes are often bid 10 points or so lower than their global-sized brethren even though Smartnotes are as senior as any GMAC senior debt. Try telling your client that their bond is worth 10 points more than the bid when they are asking you to value their account.
There is another problem with not marking securities to market. Many securities positions backed by toxic assets have been purchased with leverage. Most leverage is in the form of short-term financing. What happens when leverage is more difficult to obtain or becomes more expensive? That could result in banks being forced to sell "hold to maturity" securities to unwind trades which are no longer profitable. At prices do you think the assets will be sold, at market prices or at the banks valuation? Pretty easy question eh?
As I mentioned earlier in this piece, the CFA Institute was against modifying MTM accounting. Already, some analysts are negatively viewing the accounting changes. I was on a conference call today conducted by bank and finance analysts from both the equity and fixed income sides of the business and both stated that they believe that the change to MTM will not materially improve bank prospects and that bank equity price rallies may be short-lived.
The analysts also point out that the government, as part of the stress tests, does not consider unrealized losses when reviewing the banks. Changing MTM or not will not affect the government's decisions after reviewing the banks. My guess is that the government will review assets and "advise" banks to hit bids when the government believes it necessary and will inject more capital into affected banks in the form of convertible preferreds. What the banks think their assets are worth will be irrelevant when it comes to the governments review. If CFA chartered analysts believe that banks conjuring up their own asset values to be problematic, we could see less positive research reports from around Wall Street.
Does this mean bank bonds, or even trust preferreds, should be avoided? Heck no! JPM bonds and preferreds are cheap and are suitable for investors with moderate risk tolerances. Those who can withstand some volatility should consider GE Capital and Merrill Lynch senior notes. Political as well as economic realities make the aforementioned bonds more volatility instead or viability concerns.
Lastly, I do appreciate my readers efforts to spread the word about the existence of this publication. However, please remember that this is an underground publication. E-mailing me on the desk at work asking to be added to the list is not good for my employment prospects.
Mr. Glassman expressed concerns that the markets could be come concerned that banks may over value toxic assets and could be encouraged to take more risks. Mr. Glassman is not alone. The CFA Institute (members of which make up the majority of securities analysts) also has spoken out against modifying or eliminating mark to market.
Mr. Glassman was in the midst of a valiant defense of MTM when Kudlow and Forbes began twisting. They both began harping that banks usually hold loans until maturity and that they should not be marked to market. They then cut off Mr. Glassman. The twist was not in Mr. Kudlow's and Mr. Forbes' argument that banks usually hold loans to maturity (although that is not always the case), but rather because banks often do hold loans to maturity, they WERE NEVER REQUIRED TO MARK LOANS TO MARKET. Here lies the rub.
Modifying MTM permits banks to now not mark securities to market if the bank believes the market price does not reflect the true value of the security. What a great idea. I wish I had that ability when I was trading. Will others be permitted to do this as well? We have all tried to get bids for illiquid securities that we or are clients own. Sometimes, because of illiquidity, market bid prices are low. One can even see this in securities such as GMAC Smartnotes. Because of illiquidity, GMAC Smartnotes are often bid 10 points or so lower than their global-sized brethren even though Smartnotes are as senior as any GMAC senior debt. Try telling your client that their bond is worth 10 points more than the bid when they are asking you to value their account.
There is another problem with not marking securities to market. Many securities positions backed by toxic assets have been purchased with leverage. Most leverage is in the form of short-term financing. What happens when leverage is more difficult to obtain or becomes more expensive? That could result in banks being forced to sell "hold to maturity" securities to unwind trades which are no longer profitable. At prices do you think the assets will be sold, at market prices or at the banks valuation? Pretty easy question eh?
As I mentioned earlier in this piece, the CFA Institute was against modifying MTM accounting. Already, some analysts are negatively viewing the accounting changes. I was on a conference call today conducted by bank and finance analysts from both the equity and fixed income sides of the business and both stated that they believe that the change to MTM will not materially improve bank prospects and that bank equity price rallies may be short-lived.
The analysts also point out that the government, as part of the stress tests, does not consider unrealized losses when reviewing the banks. Changing MTM or not will not affect the government's decisions after reviewing the banks. My guess is that the government will review assets and "advise" banks to hit bids when the government believes it necessary and will inject more capital into affected banks in the form of convertible preferreds. What the banks think their assets are worth will be irrelevant when it comes to the governments review. If CFA chartered analysts believe that banks conjuring up their own asset values to be problematic, we could see less positive research reports from around Wall Street.
Does this mean bank bonds, or even trust preferreds, should be avoided? Heck no! JPM bonds and preferreds are cheap and are suitable for investors with moderate risk tolerances. Those who can withstand some volatility should consider GE Capital and Merrill Lynch senior notes. Political as well as economic realities make the aforementioned bonds more volatility instead or viability concerns.
Lastly, I do appreciate my readers efforts to spread the word about the existence of this publication. However, please remember that this is an underground publication. E-mailing me on the desk at work asking to be added to the list is not good for my employment prospects.
Wednesday, April 1, 2009
Ooh That Smell
Ooh, ooh that smell
Can't you smell that smell?
Ooh, ooh that smell
The smell of death surrounds you.
~ Lynyrd Skynyrd
There a rotting smell on Wall Street and it may be the toxic assets on bank balance sheets. Bloomberg columnist, David Reilly discusses a topic often covered by yours truly. If his commentary sound familiar it should as it is exactly what I have been saying since 2007. Mr. Reilly writes:
Banks Demand Perfume for Rotting Balance Sheets: David Reilly
Share | Email | Print | A A A
Commentary by David Reilly
April 1 (Bloomberg) -- Investors crave clarity about what banks are really worth.
Accounting-rule makers aren’t giving it to them.
If anything, proposals to relax mark-to-market accounting and sidestep recognition of some losses will only confuse investors. When lumped with the Treasury Department’s bank- bailout plan, the proposals will make it even more difficult to gauge bank strength.
This will give investors new reasons to shun bank stocks and debt, for fear of being blown up by dangers they can’t see or understand.
The problem stems from banks’ refusal to face up to losses, and a congressional directive that the Financial Accounting Standards Board “fix” mark-to-market accounting. What Congress, at the urging of bankers, really meant was, “Make bank losses disappear!”
The FASB is due tomorrow to debate proposals aimed at doing just that. The board is so desperate to please Congress, it didn’t give investors time to consider the plans.
Congress isn’t worried about that. It seems to believe that if banks can hide the gangrenous rot on their books, investors won’t turn away.
Mark-to-market accounting is a roadblock because it requires banks to use often-depressed market prices to value some assets. That makes it a sometimes painful reality check.
Massage Marks
The funny thing is banks don’t mark most of their balance sheets to market prices. Still, many want the FASB to allow them to massage the marks they do take.
That would be in keeping with banks’ preference to use prices based on their own views of value, which often overlook the consequences of shoddy lending.
Investors have given up on that approach. A March 24 report from Goldman Sachs Group Inc. analyst Richard Ramsden shows why. He estimated that Bank of America Corp., Citigroup Inc. and JPMorgan Chase & Co. are all carrying commercial mortgages at 100 percent of face value.
Yet commercial mortgages may be the next shoe to drop for banks. “Commercial credit losses are likely to be quite onerous during 2009,” Friedman Billings Ramsey Group Inc. analyst James Abbott wrote in a report this week. These losses “will be significantly larger than what most are expecting.”
Room to Monkey
No surprise then that many investors don’t want banks to have room to monkey around with mark-to-market values. Yet this is what the FASB plans to give them.
To understand how requires a look at mark-to-market mechanics. When a bank prices mark-to-market holdings, it discloses the reliability of the values used, grouping them into three different levels.
Level 1 prices are securities such as publicly traded stocks. Level 2 contains instruments that don’t have easy-to-see prices, but whose worth is based on things that have observable values.
Level 3 contains hard-to-value assets, or ones that trade infrequently. Prices for these rely heavily on management estimates. That is why this category has been called, among other things, mark-to-make-believe.
Banks want to move even more assets into this bucket because they can come up with their own values. Banks can’t do this unless there are few if any trades in a security, or they can argue that transactions are distressed sales that should be ignored.
Helping Hand
The FASB plans to help out by letting banks consider many sales to be distressed unless proven otherwise. Or banks could ignore prices if there are only a handful of trades. (That, by the way, seems to conflict with Securities and Exchange Commission guidance.)
The FASB’s approach is predicated on the idea that today’s markets are abnormal, so prices and trading often aren’t realistic. This ignores that what we considered normal in recent years was a mirage brought about by the biggest housing and credit bubble of all time.
In light of that, today’s market conditions might be the new normal. Accountant rules shouldn’t try to decide whether this is the case or not.
Nor should they try to distinguish between distressed and orderly sales. This supposes that banks and auditors can divine a seller’s intent and situation.
They can’t. Because of this, the FASB is forced to come up with vague criteria that give banks leeway to disregard prices they don’t like.
Higher Value
Or as the CFA Institute’s Center for Financial Market Integrity said in a comment letter, “This is an almost certain invitation to having toxic and other problem assets being reflected at a value much higher than actual market value.”
There is also the issue of the Treasury’s bailout plan. Will prices resulting from purchases of bank loans and securities be considered market values? Will banks have to use them for similar holdings on their books, even if that results in losses?
The FASB’s proposal makes it more likely banks will argue these sales don’t represent market values they have to use. In that case, banks may be able to use the Treasury program to cherry-pick values they like while disregarding those that would cause balance-sheet pain.
The FASB’s mission is to craft rules that give investors clear, relevant financial information. Its latest proposals are nothing more than sops to the banks.
If adopted, they will only confirm for investors that markets are now a rigged game.
(David Reilly is a Bloomberg News columnist. The opinions expressed are his own.)
To contact the writer of this column: David Reilly at dreilly14@bloomberg.net
Mr. Reilly is correct in his assessment. The banks want the ability to cover up the stench. Kind of like a pocket full of posies to cover the stench of the . He also mentions the three levels of assets, including my oft mentioned "Level III" which is used by banks to bury the rotting assets. The FASB is being coerced by heavily lobbied politicians to permit banks to ignore and even cover up problems on their balance sheets. All the perfume and flowers in the world will not cover the stench of these putrid assets.
Of course, equity investors don't care. They just want a reason for a rally. Once a rally is underway, they can unwind long positions profitably. However, rallies tend to feed on themselves and the irrational exuberance sets in. Once it is realized that the rooting assets continue to spoil balance sheets the correction could be severe and painful.
Still retail doesn't learn. On article in this evening's online Wall Street Journal reports that retail investors are strong buyers of Citi. Reasons given by these Wall Street wizards include Citi CEO Vikram Pandit's comments that the bank will not need more capital and that things can't get much worse for the bank. I say: wait for the stress test.
When I first started in the business as a trading assistant at E.F. Hutton, the traders told me of the so-called "odd-lot contrarian indicator". The thinking is that whatever retail is doing, do the opposite. This has served me well over the years. During my days as a retail corporate bond trader at the late great Wertheim Schroder, I would spend sleepy summer days being the other side on various retail trades I thought to be foolish. This went a long way to padding the ol' P & L. Keep that in mind the next time a client or a retail stock jockey comes up with the next trade idea.
There has been much confusion among retail investors and advisers with regards to GMAC's relationship to GM. Let's be clear. GMAC is not the same as GM. They do not share capital structures. They never have, not even before the 51% sale to Cerberus. This is not uncommon in the corporate world. Such relationships are found within companies such as Verizon, AT&T, Entergy and Southern Company where the parent does not guaranty the debt of the subsidiaries or vice versa.
Notice how there has been no mention of GMAC bondholders negotiating recovery with GM or the government? This is because GMAC bonds are not involved! GMAC is a separate entity (a similar situation exists between Ford and Ford Motor Credit). Also, GMAC is a bank holding company, received $5 billion of TARP money last December and can (in theory) issue FDIC-backed TLGP bonds.
There is little hope of a GM recovery (inside or outside of bankruptcy) without a functioning GMAC. GMAC provides financing not only for consumers, but also for dealers who borrow to finance inventory. No GMAC means no dealers which means no GM. The thinking is that once it is determined that GM will definitely building cars (even in Ch. XI if necessary), GMAC could be given the go ahead by the government to issue TLGP bonds. This is why short-term GMAC bonds continue to trade in the $70 to $90 range depending on the structure and maturity. GM bonds are trading in the teens. The Wall Street Journal reported that a group of large GM bondholders were seeking recovery of 33 cents on the dollar (most of which would be paid in the form of stock and new debt). This group of bondholders were rebuffed by GM and were told to lower their expectations. GM bonds have almost no chance of paying off at par.
GMAC bonds do have a chance of paying off as planned, at least in the near term. As long as GM is building cars, GMAC will probably be around. However, if GM bondholders and the UAW play hardball and GM ends up in a Ch. VII liquidation, GMAC would likely have to separately file for bankruptcy protection. This is unlikely, but possible.
It is also possible that GM is permitted to fail several years down the road. If the economy is on a more solid footing and GM is not profitable and not systemically (or politically) as important, the company could be permitted to fail. This would drag down GMAC. This is why longer-dated GMAC bonds are trading between $30 and $60 depending on structure and maturity. Also, GMAC Smartnotes, which are senior notes (as senior as any large global issue) trade as much as 10 points lower than their large global brethren. These facts make it difficult for many investors to make decisions as to what they should do with their GMAC bonds.
In my opinion it comes down to suitability. If one cannot take the heat, get out of the kitchen. However, those who have a more aggressive tolerance of risk may want to hang on. It is unlikely that GMAC bonds will be worthless at any point and, due to political reasons, it is unlikely that GM would be permitted to shut its doors in 2009. The likely result is that GMAC 2009 bonds will pay on schedule even as GM bonds are worked out at cents on the dollar.
Can't you smell that smell?
Ooh, ooh that smell
The smell of death surrounds you.
~ Lynyrd Skynyrd
There a rotting smell on Wall Street and it may be the toxic assets on bank balance sheets. Bloomberg columnist, David Reilly discusses a topic often covered by yours truly. If his commentary sound familiar it should as it is exactly what I have been saying since 2007. Mr. Reilly writes:
Banks Demand Perfume for Rotting Balance Sheets: David Reilly
Share | Email | Print | A A A
Commentary by David Reilly
April 1 (Bloomberg) -- Investors crave clarity about what banks are really worth.
Accounting-rule makers aren’t giving it to them.
If anything, proposals to relax mark-to-market accounting and sidestep recognition of some losses will only confuse investors. When lumped with the Treasury Department’s bank- bailout plan, the proposals will make it even more difficult to gauge bank strength.
This will give investors new reasons to shun bank stocks and debt, for fear of being blown up by dangers they can’t see or understand.
The problem stems from banks’ refusal to face up to losses, and a congressional directive that the Financial Accounting Standards Board “fix” mark-to-market accounting. What Congress, at the urging of bankers, really meant was, “Make bank losses disappear!”
The FASB is due tomorrow to debate proposals aimed at doing just that. The board is so desperate to please Congress, it didn’t give investors time to consider the plans.
Congress isn’t worried about that. It seems to believe that if banks can hide the gangrenous rot on their books, investors won’t turn away.
Mark-to-market accounting is a roadblock because it requires banks to use often-depressed market prices to value some assets. That makes it a sometimes painful reality check.
Massage Marks
The funny thing is banks don’t mark most of their balance sheets to market prices. Still, many want the FASB to allow them to massage the marks they do take.
That would be in keeping with banks’ preference to use prices based on their own views of value, which often overlook the consequences of shoddy lending.
Investors have given up on that approach. A March 24 report from Goldman Sachs Group Inc. analyst Richard Ramsden shows why. He estimated that Bank of America Corp., Citigroup Inc. and JPMorgan Chase & Co. are all carrying commercial mortgages at 100 percent of face value.
Yet commercial mortgages may be the next shoe to drop for banks. “Commercial credit losses are likely to be quite onerous during 2009,” Friedman Billings Ramsey Group Inc. analyst James Abbott wrote in a report this week. These losses “will be significantly larger than what most are expecting.”
Room to Monkey
No surprise then that many investors don’t want banks to have room to monkey around with mark-to-market values. Yet this is what the FASB plans to give them.
To understand how requires a look at mark-to-market mechanics. When a bank prices mark-to-market holdings, it discloses the reliability of the values used, grouping them into three different levels.
Level 1 prices are securities such as publicly traded stocks. Level 2 contains instruments that don’t have easy-to-see prices, but whose worth is based on things that have observable values.
Level 3 contains hard-to-value assets, or ones that trade infrequently. Prices for these rely heavily on management estimates. That is why this category has been called, among other things, mark-to-make-believe.
Banks want to move even more assets into this bucket because they can come up with their own values. Banks can’t do this unless there are few if any trades in a security, or they can argue that transactions are distressed sales that should be ignored.
Helping Hand
The FASB plans to help out by letting banks consider many sales to be distressed unless proven otherwise. Or banks could ignore prices if there are only a handful of trades. (That, by the way, seems to conflict with Securities and Exchange Commission guidance.)
The FASB’s approach is predicated on the idea that today’s markets are abnormal, so prices and trading often aren’t realistic. This ignores that what we considered normal in recent years was a mirage brought about by the biggest housing and credit bubble of all time.
In light of that, today’s market conditions might be the new normal. Accountant rules shouldn’t try to decide whether this is the case or not.
Nor should they try to distinguish between distressed and orderly sales. This supposes that banks and auditors can divine a seller’s intent and situation.
They can’t. Because of this, the FASB is forced to come up with vague criteria that give banks leeway to disregard prices they don’t like.
Higher Value
Or as the CFA Institute’s Center for Financial Market Integrity said in a comment letter, “This is an almost certain invitation to having toxic and other problem assets being reflected at a value much higher than actual market value.”
There is also the issue of the Treasury’s bailout plan. Will prices resulting from purchases of bank loans and securities be considered market values? Will banks have to use them for similar holdings on their books, even if that results in losses?
The FASB’s proposal makes it more likely banks will argue these sales don’t represent market values they have to use. In that case, banks may be able to use the Treasury program to cherry-pick values they like while disregarding those that would cause balance-sheet pain.
The FASB’s mission is to craft rules that give investors clear, relevant financial information. Its latest proposals are nothing more than sops to the banks.
If adopted, they will only confirm for investors that markets are now a rigged game.
(David Reilly is a Bloomberg News columnist. The opinions expressed are his own.)
To contact the writer of this column: David Reilly at dreilly14@bloomberg.net
Mr. Reilly is correct in his assessment. The banks want the ability to cover up the stench. Kind of like a pocket full of posies to cover the stench of the . He also mentions the three levels of assets, including my oft mentioned "Level III" which is used by banks to bury the rotting assets. The FASB is being coerced by heavily lobbied politicians to permit banks to ignore and even cover up problems on their balance sheets. All the perfume and flowers in the world will not cover the stench of these putrid assets.
Of course, equity investors don't care. They just want a reason for a rally. Once a rally is underway, they can unwind long positions profitably. However, rallies tend to feed on themselves and the irrational exuberance sets in. Once it is realized that the rooting assets continue to spoil balance sheets the correction could be severe and painful.
Still retail doesn't learn. On article in this evening's online Wall Street Journal reports that retail investors are strong buyers of Citi. Reasons given by these Wall Street wizards include Citi CEO Vikram Pandit's comments that the bank will not need more capital and that things can't get much worse for the bank. I say: wait for the stress test.
When I first started in the business as a trading assistant at E.F. Hutton, the traders told me of the so-called "odd-lot contrarian indicator". The thinking is that whatever retail is doing, do the opposite. This has served me well over the years. During my days as a retail corporate bond trader at the late great Wertheim Schroder, I would spend sleepy summer days being the other side on various retail trades I thought to be foolish. This went a long way to padding the ol' P & L. Keep that in mind the next time a client or a retail stock jockey comes up with the next trade idea.
There has been much confusion among retail investors and advisers with regards to GMAC's relationship to GM. Let's be clear. GMAC is not the same as GM. They do not share capital structures. They never have, not even before the 51% sale to Cerberus. This is not uncommon in the corporate world. Such relationships are found within companies such as Verizon, AT&T, Entergy and Southern Company where the parent does not guaranty the debt of the subsidiaries or vice versa.
Notice how there has been no mention of GMAC bondholders negotiating recovery with GM or the government? This is because GMAC bonds are not involved! GMAC is a separate entity (a similar situation exists between Ford and Ford Motor Credit). Also, GMAC is a bank holding company, received $5 billion of TARP money last December and can (in theory) issue FDIC-backed TLGP bonds.
There is little hope of a GM recovery (inside or outside of bankruptcy) without a functioning GMAC. GMAC provides financing not only for consumers, but also for dealers who borrow to finance inventory. No GMAC means no dealers which means no GM. The thinking is that once it is determined that GM will definitely building cars (even in Ch. XI if necessary), GMAC could be given the go ahead by the government to issue TLGP bonds. This is why short-term GMAC bonds continue to trade in the $70 to $90 range depending on the structure and maturity. GM bonds are trading in the teens. The Wall Street Journal reported that a group of large GM bondholders were seeking recovery of 33 cents on the dollar (most of which would be paid in the form of stock and new debt). This group of bondholders were rebuffed by GM and were told to lower their expectations. GM bonds have almost no chance of paying off at par.
GMAC bonds do have a chance of paying off as planned, at least in the near term. As long as GM is building cars, GMAC will probably be around. However, if GM bondholders and the UAW play hardball and GM ends up in a Ch. VII liquidation, GMAC would likely have to separately file for bankruptcy protection. This is unlikely, but possible.
It is also possible that GM is permitted to fail several years down the road. If the economy is on a more solid footing and GM is not profitable and not systemically (or politically) as important, the company could be permitted to fail. This would drag down GMAC. This is why longer-dated GMAC bonds are trading between $30 and $60 depending on structure and maturity. Also, GMAC Smartnotes, which are senior notes (as senior as any large global issue) trade as much as 10 points lower than their large global brethren. These facts make it difficult for many investors to make decisions as to what they should do with their GMAC bonds.
In my opinion it comes down to suitability. If one cannot take the heat, get out of the kitchen. However, those who have a more aggressive tolerance of risk may want to hang on. It is unlikely that GMAC bonds will be worthless at any point and, due to political reasons, it is unlikely that GM would be permitted to shut its doors in 2009. The likely result is that GMAC 2009 bonds will pay on schedule even as GM bonds are worked out at cents on the dollar.
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