Fixing A Hole

Yesterday's equity rally in the financial sector was not replicated in the fixed income market. Unlike the equity market, which is subject to alternate bouts of euphoria and despair, the fixed income market (specifically the corporate bond and CDS markets) tend to react to substance or lack thereof. Yesterday's stock market rally was driven by one bank CEO stating that his firm had a good first two months and renewed calls for a suspension or modification of mark-to-market accounting. The fixed income markets were having none of it. However, the fixed income markets reacted today to something possibly of substance.

On March 8, 2008 I compared the economy / banking system to a ship with a breached hull. The breached hull representing bank balance sheets containing toxic assets. I compared asking investors too invest in banks with toxic assets based on government promises of support to booking passage on a ship with a gash in its hull based on promises by the company to use as many pumps as required to keep the ship afloat. My belief is that investors would not jump on the banks' bandwagons unless the toxic assets left bank balance sheets and the damage could be assessed. Today, Treasury Secretary Tim Geithner announced that the government's rescue plan will involve giving needy banks even more capital to "encourage them to sell toxic assets (possibly to the street at "market" prices). Following Mr. Geithner's comments, bank bond credit spreads began to tighten and CDS spreads improved, even though the banks may have to finally realize losses.

Why would bond market cheer banks taking realized losses? Because unlike the equity markets filled with cheerleaders, such as my former colleague Larry Kudlow, bond market participants under stand that some banks have truly impaired balance sheets and that many of their assets are permanently impaired. However, they also know that many large banks will survive this, either intact or by being divided into smaller, more manageable entities. The bond market wants to know the truth and not to be shielded from the truth using shady accounting practices (marking to model, etc.).

Does Mr. Geithner's announcement mean that is time to invest in the banks? Possibly, but as we have experienced with TARP from the beginning, the rules can change before they are ever implemented. Also, the additional cash infusions may come with strings attached which could be detrimental to shareholders. However, bonds issued by large banks which have not received multiple TARP injections (one injection is ok). Although I believe that bonds issued by JPM, GS, MS, PNC and USB will probably be money good regardless of maturity, investors wanting an added measure of protection should invest in bonds maturing within the Temporary Liquidity Guarantee Program period. My thinking is that since a default on one bond is a default on all bonds, the government would be on the hook for $10s billons of bonds (principal and interest). If necessary, the government would likely order a troubled bank to sacrifice investors lower on the capital structure to ensure that bond repayments are made. TLGP makes bonds of a recently-hammered institution a possible buying opportunity.

GE Capital has been battered in the fixed income markets. Even the normally-rational fixed income markets have pounded GE Capital bonds and CDS. The probable reason for this is that the fixed income market wants GE CEO Jeff Immelt to strengthen GE's implicit, but not legal, backing of GE Capital. In spite of being a bank holding company, being TARP eligible and issuing TLGP bonds, GECC debt prices have plummeted. This appears to be the work of the bond vigilantes. The vigilantes know full well that GE is not going to spin off GECC. It would cost them $10s of billions of capital and an advance announcement (some say as much as three years) to do so. As GECC provides GE with approximately 40% of its revenue, it is more cost effective for GE to support its finance unit. Besides, the government is likely to force Mr. Immelt to support GECC with the significant amount cash it has on its balance sheet. Also, GECC has $37B in cash, continued access to TLGP (approximately another $70B) and $54B of CD deposits (source Citi Investment Research). Although continued economic negativity could continue to deteriorate GECC's results, credit downgrades, not debt defaults, appear to be the most likely outcome.

The inherent volatility makes GECC debt most suitable for sophisticated investors with moderate risk tolerances or aggressive investors. There is no reason to extend very far out on the yield curve. Either a prolonged economic downturn or higher long-term interest rates make investing within the TLGP period (June 2012) the best risk vs. reward strategy.GE Capital Global Sr. Notes 6.00% due 6/15/12 was priced today (net) at 93.67 8.257%. This represents an attractive investment for investors who want high yield with volatility, but probably not viability risk.


Earlier I mentioned that banks may sell assets at market values after receiving more government funds. This takes the debate over mark-to-market off the table, if this is how it plays out. I would like to mention that although many (equity-oriented) pundits are advocating a suspension or modification of MTM accounting, the fixed income market has been against doing so. Although not perfect, MTM can help to keep banks "honest" Imagine how deep banks could have dug themselves of marking to market did not expose their troubled assets. Those who want to modify or eliminate MTM want to do so for their own gains (or to minimize their losses). Having to 'fess up helps to reign in risk taking. We have an example of what a lack of transparency can look like.

Many of the most toxic assets were held in off-balance sheet structures such as conduits or SIVs. As these were off balance sheet, the assets never had to be marked to market. They were usually set up of sure (some in the Channel Islands, mimicking Enron) where there is no oversight. As the collateral began to fail it caught investors by surprise. When collateral failed (notice I said fail, not simply marked-to-market), this resulted in events of defaults triggering mechanisms which brought these assets back onto bank balance sheets. At that time they had to be marked (sometimes). According to an analyst friend of mine, there is at least one large bank which has only marked a relatively small portion of its assets to market.Give banks a free ride not to mark assets and they don't even have to go through the trouble of creating off-balance sheet entities. They would be able to hold God-knows-what on their balance sheets. The next crisis could dwarf the current crisis. This is as bad as the current policy of trying to fix the past easy loan bubble with a new easy loan bubble.

Speaking of crisis, the data is indicating that the economic crisis has spread beyond housing. Loans and credit cards are likely to weigh heavy on the banks in the coming months. Announcement of bank profits may be tempered by loan, credit card and more mortgage losses as the crisis spreads from irresponsible home buyers to responsible consumers who cannot make their payments because they lost their jobs (a trend expected to continue). The next round of this bout is about to begin.