Wall Street was ecstatic with a temporary moratorium on short sales of financial stocks and the announcement that the government will create some kind of bailout fund (RTC redux?) purchase trouble mortgages, loans and related securities (CDOs, MBS, etc.) from banks. Lost in all this euphoria is how the purchase of troubled mortgage-related assets will affect banks.
Market participants need to understand that these glow-in-the-dark structures will not be purchased from the banks at par, nor will they necessarily be purchased from banks at prices which they are marked on bank balance sheets. In the case of structures to esoteric to discover prices it means that securities (known as Level III assets), which have never been marked down, will be sold at fire sale prices. This will probably lead to more poor earnings reports for financial institutions. What this plan will do, in the near-term, is to permit banks to finally rid themselves of these toxic assets.
Even though they may take more significant losses, financial intuitions will benefit from investors who can be confident in the knowledge that there are no more hidden land mines on bank balance sheets. The next debate will be if marking to market versus marking at economic value. Arguments can be made for either method. However, as a former trader, I am biased to marking to market, unless one never plans to sell that assets.
Also up for debate is whether adherence to the Basel II banking agreements, which sets bank capital requirements, is detrimental for U.S. banks by forcing them to raise capital when it is most difficult to do so, during times of distress when share prices are depressed and investors are running for cover. I say the solution is for banks to do a better job in assessing risk and not leveraging irresponsible. Quants may be brilliant people and their models may be accurate in many scenarios, but what every decision maker must remember is that past performance is not an indication of future result and that one's strategy can cause scenarios in the market which have not previously existed.
The government bailout may not be a good thing for long-term interest rates. We have seen today that the reverse flight to safety pushed long-term treasury yields higher. Investors must also remember that all this government bailing will result in the issuance of more government debt. The new supply will push treasury yields higher. The greater deficit could cause the dollar to weaken, also pushing treasury yields higher.
This leaves investors in a pickle. Short-term rates are too low and long-term rates are probably going to trend higher. I would construct a ladder or barbell using CDs or agency discount notes on the short-end and agency notes 7 to 10 years out. There is no reason for extending out further. I would also consider staying in cash for those investors not needing income at this time. Although I am not a market timer, better days are a ways down the road.
I am not yet convinced that financial sector bonds offer value as volatility may be too much for many moderate or conservative investors. The hits to balance sheets and lower profits than what we have been accustomed to at banks due to reduced leverage (not to mention increased levels of debt) could keep bank credit spreads wide and the expected price stability caused by narrowing credit spreads countering rising treasury yields may not materialize as originally thought. Stay far away from preferreds until more details of the government bailout is known, JPM, WFC and BAC exepted.
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