Take Me Out to the Ball Game

Market participants, including myself, were thrown a few curveballs today. However, none were game changers.

The first curveball came from Bank of America. A day after stating that they would (for now) offer a preferred for equity swap to holders of private shares, the bank began proceedings to offer exchanges to holders of certain non-cumulative, publicly-traded $25-par preferred stocks. The exchange is not as straightforward as that of Citi. Bank of America is assigning different consideration prices for specific preferreds. The exchange ratio (how many common shares one receives for each preferred share) will be calculated by dividing the consideration price by the five day volume-weighted average trading price up to and including 6/22/09. BAC see is using a waterfall approach. The company will take shares voluntarily offered for exchange from the first preferred on the schedule. If BAC needs more shares converted it will take shares voluntarily exchanged from the next preferred on the schedule, etc. BAC will not suspend any dividends. Please not this is not official. BAC still has to file the exchange with the SEC (which is currently in process) and the SEC has to give BAC the go ahead. Here the the waterfall schedule and consideration prices courtesy of BAC:


1 060505815 Floating Rate Non-Cumulative BAC PrE $16.25
Preferred Stock, Series E

2 060505583 Floating Rate Non-Cumulative BML PrL $16.25 Preferred Stock, Series 5

3 060505633 Floating Rate Non-Cumulative BML PrG $15.00
Preferred Stock, Series 1

4 060505625 Floating Rate Non-Cumulative BML PrH $15.00
Preferred Stock, Series 2

5 060505617 6.375% Non-Cumulative BML PrI $17.00
Preferred Stock, Series 3

6 060505740 6.625% Non-Cumulative BAC PrI $17.50
Preferred Stock, Series I

7 060505724 7.25% Non-Cumulative BAC PrJ $18.75
Preferred Stock, Series J

8 060505765 8.20% Non-Cumulative BAC PrH $20.50
Preferred Stock, Series H

9 060505559 8.625% Non-Cumulative BML PrQ $21.00
Preferred Stock, Series 8


Other banks were in offering exchanges. Here is the info I have thus far:

KeyCorp (exchange details not known):

KEYprA 5.875% Trust
KEYprB 6.125% Trust
KEYprD 7.00% Enhanced-Trust
KEYprE 6.75% Enhanced-Trust
KEYprF 8.00% Enhanced-Trust

Regions:

Regions has announced the beginning of its plan to raise the $2.5 billion equity to satisfy the government's recent stress test. Regions Financial may target the Regions 8.875% RFprZ $25-par preferred.

Fifth Third:

Fifth Third is targeting their convertible issues to raise the necessary $1.1 billion it has committed to raise as the result of their stress test. FTB IS NOT targeting $25 par retail targeted Fifth Third issues (FTBprA, FTBprB & FTBprC) outstanding which are all enhanced trust preferreds.

The other curvball (or at least a breaking ball) came from GM bondholders. The so-called steering committee of GM bondholders have tentatively agreed to revised equity compensation WITHIN the confines of a bankruptcy filing. CNBC (the fountain of misinformation) initially reported that bondholders agreed to a revised debt for equity exchange. This is not the case. Bondholders were going to accept a minority ownership stake in GM AND give up their ability to collect on CDS contracts which would pay them par on the number of bonds which default protection was purchased.

Of course, retail investors were unable to protect themselves with CDS contracts. This is the "screwing" of retail I mentioned yesterday. The post was sweetened a bit. In addition to the original 10% equity stake in GM, bondholders will also receive warrants which enable them to purchase additional shares of GM at a later date. This could give bondholders another 15% ownership stake in GM.

If bankruptcy is inevitable, why sweeten the pot and seek bondholder approval? The government wants a quick bankruptcy similar to that of Chrysler. If the creditors are all in agreement, little more than a quick review by the courts is necessary to get GM in and out of bankruptcy. Bondholders (all bondholders) have until 5:00 PM EDT on Saturday 5/30/09 to vote yes or no.

A group pf small bondholders who own approximately 20% of the outstanding debt are threatening to vote no, but the majority of bondholders are expected to approve the deal. If the majority of bondholders approve the deal, the proposed compensation will apply to ALL bondholders regardless of how they voted.

GM creditors are crediting the government's willingness to convert more if its debt to equity as a motivator to consider the revised deal. Undoubtedly, the decision to reduce the UAW's ownership stake in GM to 17% from 38%, the extra potential 15% ownership for bondholders and the fact that it will be decided in bankruptcy, allowing many institutional bondholders to receive substantial compensation were also strong motivators.

The exercising of CDS insurance contracts causes an unusual circumstance. Since bondholders will agree on the bankruptcy terms before the filing (usually agreed upon after the filing), many current bondholders will help decide what compensation their CDS counterparties will receive.

Why is this so? When CDS contracts are settled, the seller of protection pays the buyer of protection par for the amount of bonds insured. In exchange, the seller of protection receives the bonds from the buyer and then waits to receive recovery in the bankruptcy. Current institutional GM bondholders appear to be in the catbird seat.

The GM CDS situation workout may be interesting for another reason. There may be more CDS contracts written than outstanding bonds. Traders and speculators often buy and sell CDS without having actual interests in the cash bonds. In that case CDS contacts are settled for cash. Thus, if it is agreed that bondholders will receive 10 cents on the dollar in bankruptcy, the CDS could be settled where the buyer of protection receives 90 cents on the dollar instead of par since there are no bonds to exchange. Buying CDS without owning the bonds is a common and legal way of engineering a naked short.

I am hearing GM bondholder recovery estimates in the 10 cents to 12 cents on the dollar area, in the form of new stock and warrants of course. Current GM shareholders could very well be wiped out.


Stay tuned for more on the GM Saga

Please Go Away, Leave Me Alone. Don't Bother Me

"Please go away leave me alone. Don't bother me." - The Beatles.

This is something that fixed income investors may want to consider telling the government. In fact, some have been telling the government just that by deliberately avoiding investing in companies which could attract government interest. Such companies include TARP banks which may not be able (or permitted) to bay back TARP funds in the near future and companies with union workforces. The mishandling of GSE preferreds and the ill treatment afforded Chrysler senior secured creditors and GM bondholders have investors running for the hills when the government comes calling.

As predicted, GM bondholders wanted nothing to do with a bond for equity exchange which would have left them with a lilliputian 10% ownership of the company at the very subordinate equity level of the capital structure. As I have reported previously, large institutional bondholders are hedged to varying degrees with credit default swaps. This will result in substantial recovery for said bondholders. However, small bondholders may not fair so well.

When CDS contracts are settled in the traditional fashion. The seller of default protection pays the buyer of protection par (100 cents on the dollar) for the number of bonds insured. The buyer of protection then surrenders his or her bonds to the seller of protection who will seek compensation in bankruptcy. The result is that that the current bondholders may not be the parties negotiating in court. It could be companies such as TARP banks and AIG which have been among the largest sellers of default protection. These firms are very likely to bow to government wishes. What we don't know is the extent of counterparty exposure among firms beholden to the government.

Does this mean that small bondholders are screwed? It depends on one's definition of screwed. Small bondholders could be forced to accept poor levels of compensation, but at least any shares received as compensation will be new shares of a (hopefully) reformed GM as current shareholders are likely to be completely wiped out. The sad fact here is that in bankruptcies in which the government is a senior claimant (which it is here), Uncle Sam does not want to run the company in question. He only wants to be made as close to whole as possible. GM bondholders offered Uncle Sam such a deal, but were rebuffed. This is not a big deal to institutional bondholders, but really hurts the small investors.

Think the government can successfully run a business? See Amtrak.

Another great plan engineered by the U.S. government was the renegotiation and forgiveness of mortgage principal balances. I have not been a fan of such schemes as it defies contract law when the loans in question have been securitized and, in most cases, it does nothing more than delay the inevitable. Today's Wall Street Journal reports just that. Residential MBS spreads have been widening recently in spite of government efforts to support that market.

The government cannot seem to get their TALF and PPIP programs of the ground. Prospective participants want to buy assets at levels which make sense even without cheap government leverage (PIMCO has said specifically that) and are concerned that by accepting cheap government leverage, the government will want to exercise influence over the running of the companies in question, specifically setting compensation levels.

Thus far, there seems to be little benefit when investing along side the government. In fact, doing so could have negative consequences.


KeyCorp announced that it will offer trust preferred holders the opportunity to exchange their preferreds shares for common equity. Here is a link to the S-4 filing:

https://www.snl.com/irweblinkx/doc.aspx?IID=100334&DID=9566015

Bank of America announced that it will offer an exchange for privately-held preferred shares. No publicly-traded preferreds are part of the exchange.

Think that banks toxic assets may be worth par if held to "maturity"? Here are mortgage delinquency data from the FDIC:

Holiday Review

Memorial Day is now behind us. Before we sink into the so-called summer doldrums (I haven't had a slow summer since 1999), let's recap market news.

Money has been flowing into high yield bond funds at a brisk pace as investors believe the worst is over. The reach for yield has begun. However, it may have begun prematurely.

High yield bond (bonds rated below investment grade) defaults have been very modest. In fact, not only are they unusually low for a recession, they are in the range the approximate pace for typical economies of about 5%. This was discussed on Kudlow & Co. last week. This has some strategists questioning earlier forecasts of 10% or higher corporate defaults. Will defaults be milder than during past recessions? Maybe, maybe not. As they say: "Timing is everything".

During the economic boom of 2003 - 2006, corporate borrowing costs were at or near all-time lows as investors reached for yield and were willing to accept lower and lower rates of return for high yield risk. Investors went well beyond their stated risk tolerances to pick up every last basis point of yield.

This was a boon to companies with lower credit ratings as it drastically reduced borrowing costs. However as Guns and Roses sang: "Nothing lasts forever, but a cold November rain." Most high yield bonds have maturities between five and ten years. The result is that many bonds issued during the economic boom may not have to be replaced with new debt for another year, two or three.

This could be a problem for some lower-rated companies as treasury benchmarks are expected to rise. As it is unlikely that credit spreads revisit historically-tight levels last seen mid-decade, replacing current debt may be cost-prohibitive for some issuers. The real story may not be that corporate bond defaults are milder this time around, but that the so-called great moderation earlier this decade left corporate borrowers with relatively under stressed balance sheets for the time being, but judgement day is approaching. Corporate days of reckoning may be delayed, but they have not been eliminated. Companies that could afford to pay their debt at rates in the 6.00% to 8.00% area may not be able to afford borrowing costs which could be in the 10% to 12% area.

Speaking of junk bonds. The GM bond for equity exchange went over like a lead balloon. Some of my sources stated that not even 10% of outstanding bondholders signed up for a ride down GM's capital structure. Bankruptcy appears almost inevitable at this point. June 1st will be judgement day for GM as the company has stated that it cannot pay its convertible bond coming due on that date. The tough love of a true bankruptcy (as opposed to the pre-packaged sham foisted upon Chrysler creditors) may be just what GM needs to become long-term viable. Look for the Obama administration to try some last minute legal trickery to avoid a true restructuring (which would be detrimental for the UAW).

Lies, Lies, We Can't Believe A Word You Say

The truth has become very elusive to both government officials and media types. Although I don't believe that Bloomberg and Wall Street Journal reporters are deliberately distorting the news (most reporters are on the short side of their careers. It is another story with columnists), they are either misinterpreting economic data and comments by market participants and government officials or they are being told what to write by their superiors.

Case in point. Today's Initial Jobless Claims report indicated that initial jobless claims fell by 12,000 jobs from a previous report of 643,000. Most media outlets reported this as good news. First, another week of over 600,000 NEW unemployment benefits claimants is not good news. Secondly, the prior week's tally of 643,000 initial jobless claims was revised upward from 637,000. The proper way to look at the Initial Jobless Claims data is to state that since last week's report of 637,000 initial jobless claims, there have been a total of 637,000 new jobless claims (631,000 this week plus 6,000 missed in last week's tally). The situation has not improved. This can be evidenced by Continuing Claims which reported that the number of people on the unemployment dole increased to 6,662,000 from a prior revised 6,587,000.

Some misinformation is more deliberate. Treasury Secretary Tim Geithner offered rising long-term treasury yields as evidence that investors believe the economy is improving (he should talk to El-Erian of PIMCO and the FOMC). The reason long-term treasury rates are rising is because of the large quantities of current and future treasury debt issuance, an expected weaker dollar and the possibility that the U.S. could lose its AAA credit rating. He fails to mention that short-term treasury yields have fallen in recent weeks, a sign that investors still place a high priority on safety and liquidity.

Speaking of the news media, I was corresponding with an acquaintance of mine who happens to be a journalist at the Wall Street Journal. I asked him why the Credit Default situation with regard to GM bondholders has not been discussed in the media. He sent me a link to a brief article published last week in the Financial Times. Here is the link:

http://www.ft.com/cms/s/0/1e2bf9ea-3e54-11de-9a6c-00144feabdc0.html?nclick_check=1



FOMC

The FOMC is not convinced that the current signs of economic stabilization are long-lasting. The Fed minutes indicate that FOMC members believe that the recession may be longer lasting and deeper than originally forecast. Fed officials also believe that growth may be slower than to what we have become accustomed when the economy finally begins growing again in late 2010 or 2011.

I am not surprised by this. The U.S. economic has been on a 25-year high fueled by every lower interest rates. Cheaper and cheaper financing coupled with easier lending standards brought about by financial innovation has caused U.S. economic growth to explode. However, the economy will have to grow based on productivity gains and structural improvements. Potential anti-business policies which have become popular on Capitol Hill threaten do sink us into an economic morass similar to that of the 1970s.

I have not been a fan of former Fed Chairman Alan Greenspan making comments which could be perceived as undermining the efforts of current Fed Chairman Ben Bernanke. There is an unwritten rule that the preceding Fed Chairman will stay out of the spotlight as to not hamper the efforts of the presiding Fed Chairman. However, Mr. Greenspan makes some astute observations in his most recent comments.

Mr. Greenspan warned that banks need to raise large amounts of capital. The former Fed Chairman told Bloomberg News: “There is still a very large unfunded capital requirement in the commercial banking system in the United States and that’s got to be funded." He continued: “Until the price of homes flattens out we still have a very serious potential mortgage crisis.”

Readers who have been with me since my former publication (with the initials M.S.) may recall that I wrote last year that there could be no lasting recovery until home prices stabilized. I also argued that if the government had let home prices drop early on, instead of taking action to prop up prices, the damage could have been much less severe as buyers would have come off the sidelines to pick up bargains while credit was still available with less onerous terms (silly things like down payments and income verification). But hey, the government knows best.

Speaking of our Washington Wonders, they (especially President Obama and his minions) are doing a good job of re-locking the credit markets and hindering troubled asset relief. Actions taken by the administration to strong arm creditors (some of which were senior and secured) to accepting less compensation than its union benefactors (whose claims on Chrysler and GM is so subordinate they are in Hell's sub-basement) are causing institutions once interested in participating in TALF and PPIP to have second thoughts. Apparently the Obama administration believes that contract law should be usurped if it runs counter to the President's interpretation of social justice. So much for being a country of laws. We have now become a country of political whims. Some private equity funds are considering not lending money to firms with union employees. Could the administration really that naive? I'll let you decide.

This Memorial Day, please remember those who gave their all so we can enjoy our burgers and beers.

Dead Man's Curve

Some market participants have been voicing the opinion that no securities laws were violated and it was in the best interest of the country that Chrysler secured lenders accepted a settlement of 29 cents on the dollar. These same market participants believe that a 10% ownership stake is fair compensation for GM senior bond holders. Although it is true that no laws were circumvented in the Chrysler cramdown, creditors (most of which were TARP banks) were strong-armed by the Obama Auto Task Force. The GM bondholders are determined not to be bullied and the have the weaponry to keep the wolves at bay.


In today's Wall Street Journal, Scott Sperling co-president of private equity firm THL Partners states that he believes that GM bond holders to not deserve more than 10% of GM as compensation. He correctly notes that the government's loans rank senior to outstanding senior unsecured bonds. The problem is that no one is disputing this fact. The problem lies with the governments beneficial treatment of the UAW.

What is sticking in the collective craw of GM bond investors is that the UAW, which has a VERY subordinate equity-level claim on GM assets, has been elevated above senior bondholders. The current reorganization plan give the UAW a 38% ownership stake in GM while the bondholders get a 10% stake. Where is the justice in that? The Obama administration was hoping to strong-arm GM bondholders into accepting meager compensation. The problem is that there are very few TARP-receiving investors among GM bondholders and they have a method in which they can be very handsomely compensated (in dollar terms) should GM file for bankruptcy protection.

The vast majority of GM bondholders (and all of whom are members of the defacto bondholders steering committee) are institutions. Unlike individuals, institutions are able to hedge and adept at doing so. You can bet your bottom dollar that GM bondholders have purchased protection in the credit default swaps market. If GM files for bankruptcy protection, bondholder who have purchased protection (many of whom had done at a much earlier date) will receive par (100 cents on the dollar) for their bonds. GM bondholders have nothing to lose and many have much to gain by taking GM to bankruptcy.

Some pro-UAW and pro-administration pundits have criticized the bondholders counter proposal in which bondholders would get a 58% ownership stake in GM. Pundits point out that the government has a senior claim and is entitled to the largest portion of compensation for its loans. What the pundits conveniently ignore is that the bondholders plan pays back the government in full.

The plan proposed by the bondholders would give themselves 58% of GM, the UAW 40% and the government loans would be paid in full. In "normal" times this plan would garner much consideration by the government. Typically in a bankruptcy, the government wants to be financially compensated. It does not wish to own and run a company. However, these are not normal times. The government wants to ensure that "green" cars are built and the UAW is building them. One only needs to look at the UAW receiving a 55% ownership stake in Chrysler while have a VERY subordinate claim.

My colleagues and I cannot believe that the Automotive Task Force has not considered that institutional bondholders are hedged with CDS. However, judging by the previous missteps by team Rattner, it appears as they were outmaneuvered by the pros. This is why GM executives (past and present) unloaded large quantities of GM equity. Unless a proposal is put forth in which the bond holders acquire a controlling interest in GM, bankruptcy here we come.

Tomorrow we will discuss the slow growth ahead.

Get Back To Where You Belong

Yesterday I promised to discuss the new FASB ruling. After 11/15/09 banks will be forced to move their off balance sheet vehicles onto their balance sheets. The result will be that billions of dollars of assets and liabilities will need to recognized for banks. Most of these assets are considered to be securities and, thanks to a recent, notable FASB rule change, banks will not have to mark these assets to market. However, they will need to value these securities in some fashion. The bank vigilantes will want to know the details of these newly on balance sheet structures and will be on the lookout for favorable valuations by banks. These assets were not part of bank stress tests.

Speaking of stress tests, concern is building in the markets for smaller regional and local banks. Many of these banks are exposed to commercial mortgages which have little (if any) chance of paying off in full. Although the so-called "Big 19" banks are too big to fail, their smaller brethren are not. Distressed smaller banks will continue to put a crimp in mortgage lending. The worst of the banking crisis may or may not be over, but we are not out of the woods yet.

Join Together With The Band

There is an old saying which says that if you can't beat them, join them. That is exactly what is happening in some areas of the capital markets. One area is the equity market where share prices have been pushed higher by mutual funds being forced to take money of the sidelines as investor dollars continue to flow into funds. The same can be said of the high yield fixed income market. Flows into high yield funds have risen during the past month. Have investors jumped in too soon?

Maybe, maybe not. Although equity prices are rallying on not much more than hope (hope that the economy has bottomed and the economy is going to rapidly recover, its dramatic selloff during the past year was exacerbated by fear (fear that the banks were collapsing and another depression was upon us). Both the optimism now and the pessimism exhibited in 2008 and early 2009 are examples of investor overreaction. Human emotions are why markets and investing can never be reduced to mathematical formulas. There is also no "reversion to the mean" (sorry equity strategists). Truthfully there is now "mean". The markets and economy are ever-changing. Each new reality is different from the one which preceded it.

Equities are not my forte'. Fixed income is my bailiwick. Take heed of my warning that many high yield bonds have rallied too far too fast. Which ones have gone too far? I wish I knew. There lies the rub. With corporate defaults still historically low, but expected to rise, there are probably more land mines ahead. As a bond guy many of my readers may not expect me to advocate bond funds (I really don't like funds or managers for fixed income investing), but since investing in high yield bonds is a speculative endeavor and is very equity-like strategically speaking, using a bond fund for high yield bond investors may be the way to go. After all, high yield bonds should be used as speculative total return instruments and not as income-generating vehicles.

The FASB passed regulations which will force banks to move off-balance-sheet assets (many of which are toxic or potentially so) onto bank balance sheets. This could put banks under renewed pressure. More on that tomorrow.

Good Morning, Good Morning, Good Morning!

Today, fixed income investors received a few wake up calls. Whether they were listening is another matter.

The calls and e-mails keep pouring in asking if investors should participate in the GM exchange offer to swap their senior debt for common equity. I have my own opinions about going lower on the capital structure (don't do it), but it is a moot point with the GM exchange. It is not going to happen. To avoid bankruptcy, GM would need 90% investor participation in the exchange. No 90% and no one gets exchanged. Why won't most GM bondholders exchange their debt for equity? Because in a bankruptcy (if the rule of law still means anything in this country), GM creditors are entitled to much more than a 10% ownership stake.

I am not the only one who believes that a GM bankruptcy is likely. GM CEO Fritz Henderson also believes that a GM bankruptcy is inevitable. Since, unlike with Chrysler, most GM bondholders are not TARP banks, President Obama may not be able to pressure creditors into committing economic suicide.

Last week there was much euphoria on Wall Street because initial jobless claims fell. Well they're up again. Sorry boys and girls, real estate values continue to decline. Companies continue to pare workers. Retail sales are not stellar and could get worse as the beneficial effects of tax refunds wain. Better earnings among retailers have been mostly due to cost cutting. That an only go so far.

What about inflation? Optimists are quick to point out that deflation is only really occurring in food, energy and real estate. Today's PPI report bears that out. However, those were the only sectors experience consistent inflation during the last economic expansion.

I am not an equity strategist, but with few tools left to stimulate growth and consumer spending to levels seen during the two decades of falling rates beginning 1982 (can't make borrowing rates and standards lower), I think returns in the stock market over the next 1o years will have difficulty outperforming the current 10-year yield of 3.10%. That's no bull.

We're Not Gonna Take It

The following is my letter to Chrysler LLC:

am disappointed in the current situation in which Chrysler finds itself. I am even more disappointed in the way Chrysler creditors were treated. I am most disappointed in the elevation of the UAWs status in bankruptcy. I currently own five Chrysler vehicles. My most recent purchases are a 2007 Dakota Quad Cab and a 2007 Caliber R/T for my wife.

I will no longer purchase vehicles from Chrysler. I will not support a company which has a group of workers who helped run the company into the ground as its majority shareholder. It is a shame that Chrysler, the former U.S. small car leader, has to receive help from FIAT (a former U.S. market failure) for assistance.

Going forward I will only purchase vehicles made in the U.S. by foreign manufacturers in non-UAW plants

Dixie

I continue to get questions as to whether or not to exchange one's GM bonds for GM common as per the offer by GM. Besides that fact that GM probably does not get the required 90% bondholder participation to get the deal off the ground, why would anyone want to own common stock of an unrestructured GM being run by and for the benefit of the UAW and the government? Sure, one may receive approximately 30 or 40 cents on the dollar (depending on the price of GM equity), but receiving GM shares instead of cash is akin to being paid with Confederate dollars.

Think I am exaggerating? GM shares fell to a 76-year low of $1.12 after six GM executives unloaded their shares. This is telling. If GM executive believe the company's shares are essentially worthless, why should anyone own GM shares?

Mother's Little Helper

Many bulls believe that the economy will rebound sharply, mirroring its decline. Why do many strategists and prognosticators, believe this? Because it has happened before. Following every recession since the Paul Volcker area, the economy has experienced a healthy rebound. Economic recoveries were only a rate cuts (or cuts) away. Things are different today.

Today, Fed policy is extremely accommodative, even for a recession. Cutting short term borrowing rates to essentially zero has had some benefit, but we can't borrow our way out of this one. Since 1982, the economy had experienced a downward trend in borrowing costs. This enabled homeowners to refinance their homes time and time again. This put money back in the pockets of consumers. It also lowered monthly expenses allowing consumers to borrow to purchase big ticket items such as large trucks and SUVs. Lower borrowing rates also enabled consumers to afford larger, more expensive homes. Lower rates also opened up home ownership to more potential buyers. The real estate boom was on.

Accommodative Fed policy has been responsible for approximately 25 years of economic growth. However, this was only possible because of the poor policy decisions of the 1960s and 1970s. Equity strategists often talk about reversion to the mean. They are famous (or infamous) for describing the so-called mean. Could the economy finally reverting to the "mean"? Truth be told, there is no mean. The U.S. economy is dynamic. There is no mean, but we are entering a new era where the economy will be based more productivity and less on leverage.

If the economy will be based on productivity instead of cheap financing (after all, cheap financing has not been able to lift the economy out of the depths of the current recession), what will that mean for stock and home prices? Both asset classes will experience gradual long-term gains, but not the booming markets to which we have become accustomed. This is your grandfather's economy, without the industrial base.

This is not a bad thing, as long as the politicians can leave things alone. Politically-motivated policies to preserve jobs which have been outdated or to preserve industries which can be conducted in areas of the world which have a comparative advantage over the U.S. could result in inflation and higher rates accompanied by slow growth (see the 1970s and the Arthur Burns Fed). However, as long as the Fed is permitted to function independently of the administration, the economy should be alright. Just don't expect consistent double digit equity returns. Also, don't expect fund mangers to out perform the market by much. Many fund managers used the magic of leverage to produce above average returns. Look for leverage to be less in vogue. As the population ages, look for more emphasis to be placed on income vehicles such as bonds.


What does this mean for financial advisers? You MUST understand the capital markets. What does this mean for investors? You MUST understand the capital markets. Both advisers and investors must resist the urge to incur excessive risk in the quest for yield. Bulls make money, bears make money, but hogs get slaughtered

The Long and Winding Road

The equity markets trended lower as market participants took some profits off the table. Prices of long-dated treasuries rose today after the Fed purchased $3.51 billion of treasury bonds with maturities ranging 2026 to 2038 in an attempt to keep mortgage rates low. The Fed's attempt to reinvigorate the economy through interest rates is today's topic of discussion.

Many strategists are calling so a so-called "V-shaped recovery". Such a cycle is marked by a rapid economic decline (as we have just experienced) followed by a rapid recovery. However, no such recovery is possible as long as economic stability, never mind growth, is due to Fed policy. Many pundits point to the three-month LIBOR rate being below 1.00%. LIBOR rates have fallen due to the Fed's short-term borrowing programs and plan to buy commercial paper. Because banks can fund their short-term needs through the Fed, interbank lending has increased. The Fed is responsible for bank confidence. Mortgage rates have fallen, but not because banks are more comfortable lending for any fundamental reasons. The Fed's large purchases of treasuries, agencies and agency MBS has pushed rated lower. The Fed's extraordinary stimuli is barely keeping us flat.

Some pundits point to the fact that, other than food, energy and home prices, there isn't much deflation. That is because that, outside of food, energy and home prices, there wasn't much inflation in the years immediately preceding the recession. Prices will may not fall if they had not risen sharply during the economic boom years. If artificially low rates can only help us find a bottom, whet gets the economy back to on trend growth?

The question should be: What will on trend growth once the Fed stimulus programs are removed (after all, they cannot go on forever)? The answer is probably a long slow climb out of the economic hole we are currently in. Stifel Nicolaus strategist Joe Battipaglia believes that an elongated and modest recovery is probably in the cards. I agree with him.

Bond prices of bank bonds have improved since the release of the stress test results last Friday. It does not seem to matter that the test was not very stringent and the Fed cut some banks considerable breaks. However, the so-called Bank Vigilantes (my name for market participants who would push bank bond and stock prices lower as long as damage from toxic assets to bank balance sheets remained undisclosed) have been appeased by the stress tests. They have been appeased to the point that banks such as BAC, MS, BBT, Wachovia and just about every large bank other than Citi has been able to raise equity capital via IPOs to satisfy stress test requirements and banks have been able to issue non-FDIC guaranteed bonds to repay TARP. Banks want to separate from the government as soon as possible. Investors have been eager to invest in banks which seem poised to cut the cord. So much for the idea of investing along side of the government. Banks and their investors want to be as far from the government as is possible.


The bulls have used some ridiculous examples to prove that the economy is returning to "normal". Not only have they pointed to the lack of deflation within core economic sectors (where inflation has been tame for almost a decade), but they are pointing to percentage gains of stock prices among troubled banks. I'm sorry, a bank's stock rising from $2 to $4 could be viewed as positive, bit if that follows a decline from $30.

Again, I am not saying that the U.S. is sinking into an economic abyss just that the recovery will be long and drawn out. Bonds will rule. Corporate bonds continue to offer the best bang for the buck, but credit spreads continue to narrow as investors take cash off the sidelines. Beware anti-growth policies from the administration and Congress.

You Only Give Me Your Funny Papers.

What you don't read in newspapers will fill volumes. This is true of the remainder of the financial media as well. Today, the Non-farm Payrolls report indicated that the economy lost 539,000 jobs. The financial media has embraced this as a sign the recession is ending. AP Economics writer Jeanine Aversa believes that this is part of the data which is "piling up" that the recession is ending. The recession may be moderating, but the Non-farm Payrolls (a lagging indicator) headline number cannot be taken at face value. For one, the data was helped by the addition of 63,000 temporary government census workers. Also, prior months reports were revised downward. The March NFP number was adjusted downward to -699K. When one digs deep into the data, the job situation has not improved much.

Admittedly, NFP is a lagging indicator. However, Jobless Claims are considered to be coincidental. Much noise was made about initial jobless claims coming in at a better-than-expected 600K. Two things to consider here. First, 6ooK newly unemployed workers is bad no matter how one slices it. Secondly, continuing claims continue to rise. With delinquencies and defaults of residential and commercial mortgages, as well as credit cards, expected to rise, the employment situation may not be quite ready to rebound.

What about the strong data coming from retailers such as Walmart? It is true that retail sales did rise in April. However, there was an unsustainable bit of stimulus last month. That stimulus came in the form of tax refunds. Consumers spent tax refunds to replace worn goods and perform typical springtime home repairs, yard work, etc. We saw a similar sales increase last June when the tax rebate checks were distributed.

How about better-than-expected stress tests? The stress tests were not that stressful. Fortunately most large banks were better capitalized than fearmongers would have us believe. However, there were some problem children. Bank of America needs to raise $33.9B of common equity to satisfy government regulators. The bank plans on doing so by issuing new common equity and converting institutional preferred shares. BAC also issued its first non-TLGP bond since before TARP. BAC like other large banks, with the exception on Citi, to get themselves out from under TARP. Also, BAC will not convert its government preferreds to common equity. BAC wants the government out of its hair and rightfully so.

Speaking of Citi. Will someone please tell CNBC's Charlie Gasparino that Citi did not need to raise "only" $5.5B. Citi had previously began a preferred exchange which would raise up to $54B of tangible common equity. This is something no other large bank has done. Get with the program Charlie.

Kudos to Citi CEO Vikram Pandit. This much-maligned executive, who had absolutely nothing to do with Citi's plight, was optimistic yet honest with employees at today's town hall meeting, according to sources. Mr. Pandit acknowledged that Citi will not focus on repaying TARP at this time. This is likely due to the fact that the government is still providing a $300 billion backstop on very troubled assets on Citi's balance sheet. Another factor is that the government will own 36% (the largest single piece) of Citi following the preferred to equity exchange. As Illinois Senator Dick Durbin pointed out in a letter to the Wall Street Journal, Citi has been on board with government mortgage relief efforts. The government may be looking to use Citi as another GSE. Citimac has a certain ring to it. Citi is on the right track, as long as the government takes a passive role.

In spite of my shooting holes in media and market bulls optimism on the economy, all is not bad in the fixed income markets. Corporate bonds in the financial sector sold off more than they should have during the panic of a few months ago. Although prices of said bonds have rebounded as credit spreads have narrowed, outstanding values abound. I mean really, 6.00% to 8.50% returns for senior bonds issued by the "Big 19" banks? Baby-boomers should be all over these bonds.

Preferred stock investors who are enjoying significant price increases due to preferred to equity exchanges should consider swapping them for corporate bonds or at least trust preferreds. This is the first time in my over two decades trading bonds that investors can pick up yield by moving up the capital structure. Make no mistake, once the preferred to equity exchange offers end, preferreds eligible for exchange will suffer significant price depreciation, However, bonds and trust preferreds should perform better as bank balance sheets are repaired. Take the profits and increase your quality. Bulls make money, bears make money, but hogs get slaughtered.

You Spin Me Right, Right Baby Right Round

The Government released the results of stress tests conducted for the "Big 19" banks. There weren't too many surprises. Among the strongest are JPM, Goldman and USB, all of which need no new tangible common equity. Among the banks needing significant common equity raises are BAC, Wells Fargo and a large New York-based bank whose name rhymes with "iti." What you say? That bank only needs $5.5 billion? Not so fast Sparky. There is something which is left out of this story.

"Iti" bank has already put in motion a plan to convert preferred shares into common equity. Some of my readers are aware of the extent of said bank's tangible common equity raise, but some may not be as well informed. Here is the truth.

Back in February, the government told "Iti" to convert preferred shares to common. The government will match the total conversion put forth by sovereign wealth funds and shares of non-cumulative preferreds which trade in the open market, up to $27B. If "Iti" cannot reach $27$27B worth of non-cumulative preferreds exchanged, the bank is to extend the offer to enhanced trust preferred holders and, if still not enough convert, trust preferred holders. That's right boys and girls, "Iti" is already committed to raising $54B! Wait, it gets better. Add today's announced $5.5B of additional TCE need and the amount is just shy of $60B. "Iti" needs to raise almost twice as much TCE as its closest peer, BAC. Let the spin begin.

The spin should be short-lived as Street analysts should be out over the weekend lambasting the stress tests as government fluff trying to inject optimism into the markets and economy. The Fed sees bank losses possibly reaching $599B by year end if the economy worsens. In spite of the optimism pervading the street from a better than expected initial jobless claims number (never mind that there were 600,000 new claims and that continuing claims climbed again indicating that hiring is soft) and from better retail sales data (wait until the short-term stimulus from tax refund checks has passed) the economy is bottoming at best. It is bottoming because it cannot go any lower (I hope). I think we have discovered replacement. Submariners are not all that happy when their submarine comes to rest on the ocean floor. Sure, they are not sinking further, but how will they return to the surface. This is something that is troubling Mr. Bernanke and Mr. Geithner.

Treasury Secretary Geithner has said that the stress tests were stringent. Some bank CEOs have stated that the stress tests were too stringent. How ever "Iti's" own fixed income strategists are on record as saying that they view the government's stress test base case as a bullish case and its bearish case as a base case scenario.

Some banks have announced equity IPOs following the stress test results. Wells Fargo stated that it will raise $6 billion in common equity (it needs to raise at least $13.7B) and Morgan Stanley will raise $2 billion in common equity (it needs at least $1.8b). MS also announced that it will come to market with $3B of non-TLGP bonds. Banks must raise capital by way of non-government-backed corporate bonds to exit the TARP program and leave the government behind. BAC and "Iti" will be wards of the state for a bit longer.

The government released a statement regarding capital assistance for banks. The statement mentions the possible suspension of dividends, even for cumulative trust preferreds, should the government deem it necessary to do so. The government is firmly in charge. Here is the actual statement:

JOINT STATEMENT BY SECRETARY OF THE TREASURY TIMOTHY F. GEITHNER, CHAIRMAN OF THE BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM BEN S.BERNANKE, CHAIRMAN OF THE FEDERAL DEPOSIT INSURANCE CORPORATION SHEILA BAIR, AND COMPTROLLER OF THE CURRENCY JOHN C. DUGAN The Treasury Capital Assistance Program and the Supervisory Capital Assessment Program May 6th, 2009 During this period of extraordinary economic uncertainty, the U.S. federal banking supervisors believe it to be important for the largest U.S. bank holding companies (BHCs) to have a capital buffer sufficient to withstand losses and sustain lending even in a significantly more adverse economic environment than is currently anticipated. In keeping with this aim, the Federal Reserve and other federal bank supervisors have been engaged in a comprehensive capital assessment exercise--known as the Supervisory Capital Assessment Program (SCAP)--with each of the19 largest U.S. BHCs. The SCAP will be completed this week and the results released publically by the Federal Reserve Board on Thursday May 7th,2009 at 5pm EDT. In this release, supervisors will report-- under the SCAP “more adverse” scenario, for each of the 19 institutions individually and in the aggregate--their estimatesof: losses and loss rates across select categories of loans; resources available to absorb those losses; and the resulting necessary additions to capital buffers. The estimates reported by the Federal Reserve represent values for a hypothetical ‘what-if’ scenario and are not forecasts of expected losses or revenues for the firms. Any BHC needing to augment its capital buffer at the conclusion of the SCAP will have until June 8th,2009 to develop a detailed capital plan, and until November 9th,2009 to implement that capital plan. The SCAP is a complement to the Treasury’s Capital Assistance Program (CAP), which makes capital available to financial institutions as a bridge to private capital in the future. A strong, resilient financial system is necessary to facilitate a broad and sustainable economic recovery. The U.S. government reaffirms its commitment to stand firmly behind the banking system during this period of financial strain to ensure it can perform its key function of providing credit to households and businesses. Understanding the Results of Supervisory Capital Assessment Program The SCAP Focus on the Quantity and Quality of Capital Minimum capital standards for a BHC serve only as a starting point for supervisors in determining the adequacy of the BHC’s capital relative to its risk profile. In practice, supervisors expect all BHCs to have a level and composition of Tier 1 capital well in excess of the 4% regulatory minimum, and also to have common equity as the dominant element of that Tier 1 capital. Under the SCAP, supervisors evaluated the extent to which each of the 19 BHCs would need to alter either the amount or the composition (or both) of its Tier 1 capital today to be able to comfortably exceed minimum regulatory requirements at year-end 2010, even under an more adverse economic scenario. The SCAP capital buffer for each BHC is sized to achieve a Tier 1 risk-based ratio of at least 6% and a Tier 1 Common risk- based ratio of at least 4% at the end of 2010, under a more adverse macroeconomic scenario than is currently anticipated. The SCAP focuses on Tier 1 Common capital--measured by applying the same adjustments to “voting common stockholders’ equity”used to calculate Tier 1 capital--as well as overall Tier 1 capital, because both the amount and the composition of a BHC’s capital contribute to its strength. The SCAP’s emphasis on Tier1 Common capital reflects the fact that common equity is the first element of the capital structure to absorb loss and offers protection to more senior parts of the capital structure. All else equal, more Tier 1 Common capital gives a BHC greater permanent loss absorption capacity and a greater ability to conserve resources under stress by changing the amount and timing of dividends and other distributions. The Role of the SCAP Buffer By its design, the SCAP is more stringent than a solvency test.First, each BHC’s capital was rigorously evaluated against a two-year-ahead adverse scenario that is not a prediction or an expected outcome for the economy, but is instead a “what if”scenario. In addition, the buffer was sized so that each BHC will have a cushion above regulatory minimums even in the stress scenario. Thus, any need for additional capital and/or a change in composition of capital to meet the SCAP buffer is not indicative of inadequate current capitalization. Instead, the SCAP buffer builds in extra capital against the unlikely prospect that the adverse scenario materializes. The presence of this one-time buffer will give market participants, as well as the firms themselves, confidence in the capacity of the major BHCs to perform their critical role in lending, even if the economy proves weaker than expected. Once this upfront buffer is established, the normal supervisory process will continue to be used to determine whether a firm’s current capital ratios are consistent with regulatory guidance. The SCAP and the Capital Planning Process Over the next 30 days, any BHC needing to augment its capital buffer will develop a detailed capital plan to be approved by its primary supervisor, in consultation with the FDIC, and willhave six months to implement that plan. In light of thepotential for new commitments under the Capital Assistance Program or exchanges of existing CPP preferred stock, supervisors will consult with Treasury on the development and evaluation of the plans. The capital plan will consist of three main elements: • A detailed description of the specific actions to be taken to increase the level of capital and/or to enhance the quality of capital consistent with establishing the SCAP buffer. BHCs are encouraged to design capital plans that, wherever possible, actively seek to raise new capital from private sources. These plans should include actions such as: > Issuance of new private capital instruments; > Restructuring current capital instruments; > Sales of business lines, legal entities, assets or minority interests through private transactions and through sales to the PPIP; > Use of joint ventures, spin-offs, or other capital enhancing transactions; and > Conservation of internal capital generation, including continued restrictions on dividends and stock repurchases and dividend deferrals, waivers and suspensions on preferred securities including trust preferred securities, with the expectation that plans should not rely on near-term potential increases in revenues to meet the capital buffer it is expected to have. • A list of steps to address weaknesses, where appropriate, in the BHC’s internal processes for assessing capital needs and engaging in effective capital planning.• An outline of the steps the firm will take over time to repay government provided capital taken under the Capital Purchase Program (CPP), Targeted Investment Program (TIP), or the CAP, and reduce reliance on guaranteed debt issued under the TLGP. In addition, as part of the 30-day planning process, firms will need to review their existing management and Board in order to assure that the leadership of the firm has sufficient expertise and ability to manage the risks presented by the current economic environment and maintain balance sheet capacity sufficient to continue prudent lending to meet the credit needs of the economy. Supervisors expect that the board of directors and the senior management of each BHC will give the design and implementation of the capital plan their full and immediate attention and strong support. Capital plans will be submitted and approved bysupervisors by June 8th, 2009. Upon approval, these capitalplans will be the basis for the BHC’s establishment of the SCAP capital buffer by November 9th, 2009. Mandatory Convertible Preferred under the CAP To ensure that the banking system has the capital it needs to provide the credit necessary to support economic growth, the Treasury is making capital available under its Capital Assistance Program as a bridge to private capital in the future.A BHC may apply for Mandatory Convertible Preferred (MCP) in an amount up to 2% of risk-weighted assets (or higher upon request). MCP can serve as a source of contingent common capital for the firm, convertible into common equity when and if needed to meet supervisory expectations regarding the amount andcomposition of capital. Treasury will consider requests toexchange outstanding preferred shares sold under the CPP or the Targeted Investment Program (TIP) for new mandatory convertiblepreferred issued under the CAP. In order to protect thetaxpayer interest, the Treasury expects that any exchange of Treasury-issued preferred stock for MCP will be accompanied or preceded by new capital raises or exchanges of private capital securities into common equity. The MCP instrument is designed to give banks the incentive to redeem or replace the government-provided capital with private capital when feasible. The term sheet for MCP is available at www.financialstability.gov. The SCAP focused on the largest financial firms to ensure that they maintain adequate capital buffers to withstand losses in an adverse economic environment. Smaller financial institutions generally maintain capital levels, especially common equity, well above regulatory capital standards. There is no intention to expand the SCAP beyond the 19 BHCs that have recently completed this exercise. The Treasury reiterates that the CAP application process remains open to these institutions under the same terms and conditions applicable to the 19 SCAP BHCs. The Treasury stands ready to review and process any applications received in an expedient manner. For those firms wishing to apply to CAP, supervisors will review those firms’ risk profiles and capital positions.In addition, supervisors will evaluate the firms’ internal capital assessment processes, including capital planning efforts that incorporate the potential impact of stressful market conditions and adverse economic outcomes. Redeeming Preferred Securities Issued under the CPP Supervisors will carefully weigh an institution’s desire to redeem outstanding CPP preferred stock against the contribution of Treasury capital to the institutions overall soundness, capital adequacy, and ability to lend, including confirming that BHCs have a comprehensive internal capital assessment process.All BHCs seeking to repay CPP will be subject to the existing supervisory procedures for approving redemption requests for capital instruments. The 19 BHCs that were subject to the SCAP process must have a post-repayment capital base at least consistent with the SCAP buffer, and must be able to demonstrate its financial strength by issuing senior unsecured debt for a term greater than five years not backed by FDIC guarantees, in amounts sufficient to demonstrate a capacity to meet funding needs independent of government guarantees.

Back In The USSR

I have received many calls and e-mails asking my opinion as to whether or not investors should participate in General Motors' offer to exchange their bonds for GM common at a ratio of 225 shares per bond. Investors considering this exchange are making two mistakes.


Mistake #1: Investors are assuming that GM common shares will be worth about what they are trading at now ($1.85 or about 41 cents on the dollar per bond). Share dilution could push GM share prices lower. The fact that, if the exchange is successful and the UAW and government combine to own approximately 90% of GM when this is over means that shareholder value and growth will not be job #1.

Mistake #2: A major mistake investors are making is believing that the exchange will occur. For a successful exchange to occur and for bankruptcy to be averted under the government's, I mean under GM's plan, 90% of bondholders have to approve of the deal. I have as much chance of passing through the sun unscathed as 90% of GM bondholders accepting a deal to give up their status as senior creditors and become equity holders in an enterprise run for the benefit of the UAW and the green lobby.

The government is already taking steps to take advantage of this. The Obama administration is poised to push ahead with its so-called "Cash for Clunkers" plan. Consumers could receive rebates of up to $4,500 to trade in their current older vehicles for new "green" vehicles produced by (drum roll please) the new GM and Chrysler. Those who think that this is a good idea should consider two things. First, where do worn out batteries used in hybrids go when they where out? Usually to land fills where their lead is absorbed into the soil. Secondly, the last time government tried to help run an auto industry and preserve union jobs was the British Leyland fiasco in the 1970s. How many 2009 Triumphs are on the road these days?

The government presented the final stress test results to the "Big 19" banks today. Information (selectively chosen) will be released to the public this Thursday. During my travels last week, many financial advisers where optimistic that the results would be positive. Boys and girls, if they were positive, Tim Geithner would have been doing his Paul Revere impersonation "ready to ride and spread the alarm through every Middlesex village and farm" (apologies to Longfellow). If the information released is surprisingly positive, the market will not believe it too be factual for the market knows that something is rotten in the state of Denmark (apologies to Shakespeare). If the news is unexpectedly dire, the market will punish certain banks.

The government set guidelines for banks to pay back TARP funds. The most critical requirement is for banks to raise capital outside the Temporary Liquidity Guarantee Program. Thus far, JPM, GS, and Northern Trust have done so. Two large, troubled banks have not. One, in fact, issued $7 billion of TLGP bonds last week. Don't worry, the government is all to happy to have certain large banks in its back pocket. This will enable the government to use these banks to promote its social agenda (low income lending, mortgage forgiveness, etc.) Welcome to Amerika.

All is not lost in the capital markets, however. There are signs of life in the economy (the so-called green shoots). Although opportunities abound in the high grade corporate bond market for investors who can tolerate volatility, one must take the possible bottoming of the economy for what it is, a settling at the bottom of a deep ocean. The recovery is unlikely to be V shaped, but rather more like a U with the right side being severely elongated. The worst may be over, but a boom is unlikely this year. Beware cheerleader-driven asset bubbles.

Der Kommisar

If anyone still thinks that the Obama administration has any intention of rescuing companies and returning them to profitable, capitalist enterprises please stop drinking the Kool-Aid. It was bad enough that the government is using its influence on TARP-receiving banks to forward its agenda, now the administration is going to restructure the automakers, GM and Chrysler, to provide jobs to the UAW. The UAW's money to help buy the presidency was well spent as the administration is going out of its way to ensure that either the UAW or itself own majorities of both GM and Chrysler, ignoring the rights of creditors and, in the case of GM, a plan to make taxpayers whole.

Yesterday, Chrysler filed for Chapter XI protection after some of its creditors (nearly everyone which was not a TARP bank), declined to accept the governments plan which would have left them as minority equity owners in a company run by and for the benefit if the UAW. What is more outrageous is that President Obama heavily criticized (ripped) Chrysler's who were well within their rights to demand a larger portion of ownership in Chrysler.

GM is an even more outrageous situation. GM creditors are owed $27 billion. The government is owed $15.4 billion. Given this, it would be foolish, not to mention unfair, for GM creditors (who in a bankruptcy court have a senior claim and majority on owning GM) to accept the government's plan which would give GM creditors a 10% equity ownership in a company in which the UAW and the government would collectively own nearly 90%. That would be just plain foolish.

GM bondholders have offered a counter proposal. GM creditors want control over 58% of GM and give the UAW ownership in 40% (the remaining 2% would go to other outside investors). GM creditors also said that GM would be able to pay the government (taxpayer) loans back in full. The Obama administration declined the offer.

Many analysts and market pundits are of the opinion that creditors are trying for more cents in the dollar for compensation. What is really happening here is that GM creditors do not want to be owners in a company which will be run as a non-profit organization. Come on, how profitable can GM be with the government and the UAW running it as a workers collective? How appropriate for May Day. Not only would I not invest in GM, I would not do so with the money of my worst enemy.

This socialistic power grab could be beneficial to GMAC bondholders. The government has selected GMAC as the financier of choice for both GM and Chrysler. Being a TARP bank means that GMAC will make good on its debts, as long as GM and Chrysler are building vehicles and Obama or his ilk are in power. Welcome to the People's Republic of America. If the government and / or the UAW end up as majority owners in GM and Ford, I will not purchase a vehicle from either company as long as the situation persists. I encourage my readers to do the same.