Lost in all the speculation over what toxic assets may "really" be worth is how banks came to acquire such large quantities of toxicity. I am not referring to various events of default which sent distressed asset-backed securities and loans boomeranging back onto bank balance sheets, but rather how banks and investment banks acquired sufficient capital to engage the acquisition of large pools of toxic assets. I am talking about leverage.
Traditionally, commercial banks would lever up between 10 and 15 to 1. Investment banks would carry about 20 to 1 leverage. However, firms such as Bear Stearns and Lehman were said to carry leverage ratios of 30 to one or more. One research piece I read today states that European banks may be significantly levered up due to European bank leverage accounting rules. Could the European banks be the next shoes to drop? It is certainly possible.
Foreign or domestic, banks will be reluctant to sell assets at fire sale prices, not just because doing so would result in realized losses, but also because they wouldn't be able to successfully unwind leverage. After all, loans must be paid back (at least that had been the case in the past). Look for the banks to get nudged by the government to sell asset-backed securities and loans to buyers via the PPIP. If such sales result in losses, look for the government to inject yet more capital into the banks, possibly with strings attached.
Moody's added two banks to its list of banks raising concerns. Moody's downgraded the bonds and preferreds of BAC and WFC. Not only has Moody's downgraded BAC and WFC credit ratings, it hit very subordinate securities very hard. This is especially true of non-cumulative preferred stock. Moody's believes that BAC and WFC may have to take Citi-like measures to raise tangible common equity. Depending on exactly what transpires, BAC and WFC preferred shares could become very volatile. Could their be arbitrage strategies which cause prices of preferred shares to rise? Sure, but who is to say that, if such an exchange happens at all, that the exchange terms are as generous as those offered by Citi. Also remember, that if Citi has its way, the dividends on the non-cumulative preferreds will be permanently wiped out and the securities delisted. Those speculating on preferred exchanges re doing so in the purest sense of the word.
GDP data was downright ugly. With the exception of somewhat better home sales data the other day, there are few bright spots among the economic data. Right now the plan is to play defense. Names like Comcast and Viacom offer yield outside of bank and finance sectors. The best financials continue to be JPM, GS, PNC and USB. The GE Capital panic was overdone, but calmer heads are prevailing. Still good values remain among GE Cap bonds and PINEs preferreds. Callable agency bonds and Agency MBS also offer attractive values. High Yield appears to be cheap, too cheap. When something is too good to be true, it probably is. According to most high-yield experts, corporate defaults are expected to rise. Stay away for now. I will discuss the auto debacle this weekend. I need time to go over the disaster that is the rescue plan.
The government had better soon realize that the "repaired" economy will not look like the bubble-based economies of the past 20 years fueled by an ever-lower interest rate pyramid scheme. As Citi's technical analysts stated:
"While this might seem a ridiculous comment we honestly still think that people do not get the seriousness of this “economic de-leveraging” taking place."
"People still seem focused on the idea that this is just a financial de-leverage of the last 5 or 6 years of financial excess while we believe it is an economic de-leverage of the last 25 to 30 years worth of excess."
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