My argument against Treasury wiping out GSE preferred holders was that it would destroy investor confidence in the preferred market and any area in which the government intervened. As we have since experienced, this is exactly what has happened. Cheerleaders on the markets' sidelines have been shouting their support of government intervention, but investors have been much less sanguine. Some may argue that having a dog in the fight (I do work on a fixed income desk and own FREprZ) that I am just voicing by bias. However, I am not the only (and definitely not the most influential) critic.
The markets' aversion for anything Paulson-related should be enough proof that the government is sapping, rather than instilling, confidence in financial preferreds and common equity. However, other fixed income experts have voiced opinions similar to my own and those of many fixed income market participants. James Grant, publisher of Grant's Interest Rate Observer, has published an article in the Wall Street Journal. The following paragraphs from the article speak volumes:
"Perhaps the world has gone so far down the path of socialized finance that there's no turning back. However, the doughty remnant of capitalists should be under no illusion about the risks and opportunities they confront. They can't miss the risks. Mr. Paulson pledges that the government's bank investments will be passive and apolitical, but the record of the Depression-era Reconstruction Finance Corp. suggests that the federal government is a shareholder that can throw its weight around. Besides, would Mr. Paulson's apolitical intentions bind his successor?"
Until The government backs away from its ownership interest in the private sector, I will be fearful of a GSE-like outcome.
Saturday, October 18, 2008
Wednesday, October 15, 2008
He Talks To Angell
Former Fed governor Wayne Angell tells CNBC that the government should instill confidence in preferred shares to get investors to recapitalize troubled institutions. He went on to blame the Treasury for blowing up GSE preferreds for starting this panic and believes that the government should reverse its GSE preferred decision and invite investors to recapitalize FRE and FNM.
If li'l ole me could figure out that suspending GSE dividends was a very bad idea and Wayne Angell agrees, why didn't Paulson realize that last month? Because he and Congress are detached from the retail side of the markets.
If li'l ole me could figure out that suspending GSE dividends was a very bad idea and Wayne Angell agrees, why didn't Paulson realize that last month? Because he and Congress are detached from the retail side of the markets.
Power and Responsibility
In the Spiderman story, young Peter Parker is told this by his Uncle Ben. Uncle Ben explained that just because one can do something doesn’t mean they should. This is a lesson the banking industry (and the world) is currently learning.
Beginning with President Reagan’s push for deregulation and free markets and continuing through President Clinton’s signing off on the abolishment of the Glass-Steagall act in 1999, the U.S. economy enjoyed a degree of freedom not seen since before the great depression. Financial institutions took advantage of their newly-found power. However, we now know they fell short in the responsibility department. Thanks to the banks, we have moved from an era of free-market capitalism, to an era of government control and intervention. Goodbye Adam Smith. Hello John Maynard Keynes.
What does this mean for banks, the economy and the markets? First, the days of 20 or 30 times leverage is dead. Since common sense did not prevent this kind of levering, the government will. The government will likely try to head off crises such as we have now by constantly overseeing bank operations. This means earnings will be lower than in the recent past and equity dividends will remain somewhat low for the foreseeable future.
Secondly, the days of easy lending are over as well. Although it is true that banks are now better-capitalized, their abilities to lend hinge on investor appetite for asset-backed, mortgage-related securities. No longer will investors merely trust the credit rating services. They will want to know the specific details of the underlying collateral. Vehicles backed by lower-quality assets will be shunned by many investors, regardless of the level of seniority of the tranche in question.
Lastly, reduced leverage and the resulting reduced lending (albeit better than today’s lending environment) will keep economic growth below levels seen during the housing bubble. It will also prevent the purchasing of big ticket items, such as homes and automobiles, from reaching bubble levels. Big ticket items will now be purchased by those who can truly afford them (for the most part).
This will mean that home prices will rise, but at a pace dictated by the gradual movement of the supply glut of homes. Until home inventories fall (and they are sizeable) home prices will fall and then stagnate. Automakers which are already in precarious situations could find themselves in bankruptcy, unless they are the beneficiaries of government assistance.
Is this the end of the pain for the banks? No, they still have toxic assets on their balance sheets. They will have to take losses, unless the government buys the toxic assets at prices above what they are truly worth. Make no mistake, many (if not most) of the toxic assets on bank balance sheets have essentially failed. While the assets are not worth zero, they are not worth par and never will be. Want a hint of how bad things could be? Wachovia had to come clean as a result of it being purchased by Wells Fargo. According to Bloomberg News, Wachovia has now written down $96.7 billion. This is almost twice what Citi has written down ($54.7B). Citi is believed to have the largest collection of toxic assets. Only government over-payment via TARP or creative accounting can prevent further large writedowns at the major banks.
Preferred holders can breathe a sigh of relief now that it is clear that the government will not require banks to suspend preferred or even common dividends, so long as the banks pay dividends on government owned preferreds. There is one fact of which investors and financial advisers should be aware. Trust preferreds are SENIOR to government preferreds. In theory, banks could not pay the government and still pay the dividends on trust preferreds. Also, since trust preferreds are cumulative, investors are entitled to missed dividends as long as the issuer does not fail. Bank failures have just become much less likely thanks to the Peoples Republic of America
What does this mean for interest rates and corporate bond yields? Long-term interest rates should rise due to the new supply of government debt and the dilution of the value of the dollar. However, that may be moderated some by a continued flight to the dollar as the U.S. is still the safest place to park one’s money.
Corporate bond spreads on non-financials should not change much, narrowing somewhat, as they have not widened out in the same fashion as financials. Financial sector senior notes could experience significant spread narrowing now that the government is temporarily guaranteeing senior bonds. Although rising long-term rates could erode any capital gains benefits from spread narrowing, I believe that the spread narrowing may be enough to keep corporate bond prices stable.
For the next year or two we will be playing defense. Investors should stay with the higher quality names as the near-term economic weakness could be a death-knell for troubled companies.
Beginning with President Reagan’s push for deregulation and free markets and continuing through President Clinton’s signing off on the abolishment of the Glass-Steagall act in 1999, the U.S. economy enjoyed a degree of freedom not seen since before the great depression. Financial institutions took advantage of their newly-found power. However, we now know they fell short in the responsibility department. Thanks to the banks, we have moved from an era of free-market capitalism, to an era of government control and intervention. Goodbye Adam Smith. Hello John Maynard Keynes.
What does this mean for banks, the economy and the markets? First, the days of 20 or 30 times leverage is dead. Since common sense did not prevent this kind of levering, the government will. The government will likely try to head off crises such as we have now by constantly overseeing bank operations. This means earnings will be lower than in the recent past and equity dividends will remain somewhat low for the foreseeable future.
Secondly, the days of easy lending are over as well. Although it is true that banks are now better-capitalized, their abilities to lend hinge on investor appetite for asset-backed, mortgage-related securities. No longer will investors merely trust the credit rating services. They will want to know the specific details of the underlying collateral. Vehicles backed by lower-quality assets will be shunned by many investors, regardless of the level of seniority of the tranche in question.
Lastly, reduced leverage and the resulting reduced lending (albeit better than today’s lending environment) will keep economic growth below levels seen during the housing bubble. It will also prevent the purchasing of big ticket items, such as homes and automobiles, from reaching bubble levels. Big ticket items will now be purchased by those who can truly afford them (for the most part).
This will mean that home prices will rise, but at a pace dictated by the gradual movement of the supply glut of homes. Until home inventories fall (and they are sizeable) home prices will fall and then stagnate. Automakers which are already in precarious situations could find themselves in bankruptcy, unless they are the beneficiaries of government assistance.
Is this the end of the pain for the banks? No, they still have toxic assets on their balance sheets. They will have to take losses, unless the government buys the toxic assets at prices above what they are truly worth. Make no mistake, many (if not most) of the toxic assets on bank balance sheets have essentially failed. While the assets are not worth zero, they are not worth par and never will be. Want a hint of how bad things could be? Wachovia had to come clean as a result of it being purchased by Wells Fargo. According to Bloomberg News, Wachovia has now written down $96.7 billion. This is almost twice what Citi has written down ($54.7B). Citi is believed to have the largest collection of toxic assets. Only government over-payment via TARP or creative accounting can prevent further large writedowns at the major banks.
Preferred holders can breathe a sigh of relief now that it is clear that the government will not require banks to suspend preferred or even common dividends, so long as the banks pay dividends on government owned preferreds. There is one fact of which investors and financial advisers should be aware. Trust preferreds are SENIOR to government preferreds. In theory, banks could not pay the government and still pay the dividends on trust preferreds. Also, since trust preferreds are cumulative, investors are entitled to missed dividends as long as the issuer does not fail. Bank failures have just become much less likely thanks to the Peoples Republic of America
What does this mean for interest rates and corporate bond yields? Long-term interest rates should rise due to the new supply of government debt and the dilution of the value of the dollar. However, that may be moderated some by a continued flight to the dollar as the U.S. is still the safest place to park one’s money.
Corporate bond spreads on non-financials should not change much, narrowing somewhat, as they have not widened out in the same fashion as financials. Financial sector senior notes could experience significant spread narrowing now that the government is temporarily guaranteeing senior bonds. Although rising long-term rates could erode any capital gains benefits from spread narrowing, I believe that the spread narrowing may be enough to keep corporate bond prices stable.
For the next year or two we will be playing defense. Investors should stay with the higher quality names as the near-term economic weakness could be a death-knell for troubled companies.
Monday, October 13, 2008
No Value
No Value
There is an excellent editorial in today’s Wall Street Journal discussing the Value at Risk model and how it failed the markets during the current economic crisis. It is nice to see someone else besides myself criticize the blind reliance on models.
For years I have written of the dangers of the fire and forget method of investing. Value at Risk models are only as good as their input data. One can plug in historical data and a formula (being based on logic) can spit out a result. What a formula can never account for is the human element which is the basis of markets and the economy as a whole. The economy is not like the orbiting of the Space Shuttle or a communications satellite. Engineers can use mathematical formulas to make a satellite remain in a specified orbit. Since there is no human interaction with the direction or speed of the satellite, once in orbit, it will perform as planned by a formula. We can predict the arrival of Halley’s Comet. However, markets and economies are all about human interaction. It is why they exist. The reducing of markets and economies into mathematical formulas will always be problematic because formulas cannot predict the human mind. This is, apparently, surprising to some. It is mainly surprising to the scientists who created the formulas. My advise is to learn the markets and human nature before creating a formula.
Where did the formulas fail us? As the Journal article stated, they did not take into account the politically-motivated decisions regarding Freddie and Fannie and their social lending to people who could not afford a home or the home which they wished to purchase. The so-called Value at Risk models did not (could not) take into account that many mortgages this time around were issued with little or no documentation. Models cannot factor in home flippers who purchased multiple homes with no money down and, because they never paid down payments, have no impetus to try to make mortgage payments. Remember, these were not the roofs over their heads, but investment speculations. Even primary homeowners who put little or no money down have little incentive to pay their mortgages. Buying a home with no money down is similar to renting in that the only capital expended was to make monthly payments. If one cannot afford the monthly payments, one can simply move to a rental property with nothing lost, except for the monthly payment which would have been made anyway be it rent or mortgage payments.
Formulas should be used as guides and re-engineered to account for new market and economic developments. However, this defeats the purpose of formulas. Investment banks and hedge funds use formulas to manage large pools of money most efficiently. Constant human attention makes it less efficient to do so. Some also believe that adding more human interaction creates more volatility and unpredictability. Too bad, the markets are complex and, often, dangerous places. I would rather have a sharp and savvy trader than a reborn physicist creating formulas based on old data and having little if any market experience. This is akin to the age-old criticism of the military. Military strategies are often criticized for planning to fight the last war. History has demonstrated that the strategy which recognizes and reacts to new realities prevails.
There is an excellent editorial in today’s Wall Street Journal discussing the Value at Risk model and how it failed the markets during the current economic crisis. It is nice to see someone else besides myself criticize the blind reliance on models.
For years I have written of the dangers of the fire and forget method of investing. Value at Risk models are only as good as their input data. One can plug in historical data and a formula (being based on logic) can spit out a result. What a formula can never account for is the human element which is the basis of markets and the economy as a whole. The economy is not like the orbiting of the Space Shuttle or a communications satellite. Engineers can use mathematical formulas to make a satellite remain in a specified orbit. Since there is no human interaction with the direction or speed of the satellite, once in orbit, it will perform as planned by a formula. We can predict the arrival of Halley’s Comet. However, markets and economies are all about human interaction. It is why they exist. The reducing of markets and economies into mathematical formulas will always be problematic because formulas cannot predict the human mind. This is, apparently, surprising to some. It is mainly surprising to the scientists who created the formulas. My advise is to learn the markets and human nature before creating a formula.
Where did the formulas fail us? As the Journal article stated, they did not take into account the politically-motivated decisions regarding Freddie and Fannie and their social lending to people who could not afford a home or the home which they wished to purchase. The so-called Value at Risk models did not (could not) take into account that many mortgages this time around were issued with little or no documentation. Models cannot factor in home flippers who purchased multiple homes with no money down and, because they never paid down payments, have no impetus to try to make mortgage payments. Remember, these were not the roofs over their heads, but investment speculations. Even primary homeowners who put little or no money down have little incentive to pay their mortgages. Buying a home with no money down is similar to renting in that the only capital expended was to make monthly payments. If one cannot afford the monthly payments, one can simply move to a rental property with nothing lost, except for the monthly payment which would have been made anyway be it rent or mortgage payments.
Formulas should be used as guides and re-engineered to account for new market and economic developments. However, this defeats the purpose of formulas. Investment banks and hedge funds use formulas to manage large pools of money most efficiently. Constant human attention makes it less efficient to do so. Some also believe that adding more human interaction creates more volatility and unpredictability. Too bad, the markets are complex and, often, dangerous places. I would rather have a sharp and savvy trader than a reborn physicist creating formulas based on old data and having little if any market experience. This is akin to the age-old criticism of the military. Military strategies are often criticized for planning to fight the last war. History has demonstrated that the strategy which recognizes and reacts to new realities prevails.
Saturday, October 11, 2008
Not Short of Mistakes
This week the Dow suffered its biggest one week loss ever and the S&P suffered its worst week since 1933. Some people are lambasting the shorts as the reason for the tanking markets and while we have no love lost for short positions taken by market manipulators, negative opinions are not without some justification, Besides, the short sale suspension came off last Thursday. It was not responsible for the first three days of the sell off. The real problem is our treasury secretary Hank Paulson.
Hank's missteps began with his handling of the GSEs. Short sellers, for a variety of reasons, were beating up share prices of financial institutions and the GSEs. This was making it very costly for them to raise capital in the open market. However, they were still able to do so. Mr. Paulson in an attempt to calm market fears over the GSEs asked for and received almost unlimited power to backstop the GSEs. The market was not convinced this was a good, thing. If Mr. Paulson used his powers and seized the GSEs, preferred holders could be wiped out and that would have locked up the capital markets.
Mr. Paulson dismissed this as an overreaction. However, this is exactly what has happened. Mom and Pop investors and banks (the biggest buyers of preferred - which give much-needed Tier-1 capital) have been scared away. Bond and commercial paper buyers were scared away as Lehman and Wamu were permitted to fail. In fact it is the inconsistency of government actions which has locked up the markets.
Why has poor government decision making locked up the markets? Because, in spite of what the government and CNBC guests tell us, banks and other institutions are LOADED with bad assets. Assests which will NEVER fully recover. Since banks know what toxic assets they have and have a good idea what their counterparties have, interbank lending has basically ceased. The markets want either a cleansing of balance sheets with institutions taking their medicine or a complete government bailout, explicitly guaranteeing banks. Anything else will leave the markets locked and make a deep recession or depression possible.
Hank's missteps began with his handling of the GSEs. Short sellers, for a variety of reasons, were beating up share prices of financial institutions and the GSEs. This was making it very costly for them to raise capital in the open market. However, they were still able to do so. Mr. Paulson in an attempt to calm market fears over the GSEs asked for and received almost unlimited power to backstop the GSEs. The market was not convinced this was a good, thing. If Mr. Paulson used his powers and seized the GSEs, preferred holders could be wiped out and that would have locked up the capital markets.
Mr. Paulson dismissed this as an overreaction. However, this is exactly what has happened. Mom and Pop investors and banks (the biggest buyers of preferred - which give much-needed Tier-1 capital) have been scared away. Bond and commercial paper buyers were scared away as Lehman and Wamu were permitted to fail. In fact it is the inconsistency of government actions which has locked up the markets.
Why has poor government decision making locked up the markets? Because, in spite of what the government and CNBC guests tell us, banks and other institutions are LOADED with bad assets. Assests which will NEVER fully recover. Since banks know what toxic assets they have and have a good idea what their counterparties have, interbank lending has basically ceased. The markets want either a cleansing of balance sheets with institutions taking their medicine or a complete government bailout, explicitly guaranteeing banks. Anything else will leave the markets locked and make a deep recession or depression possible.
Thursday, October 9, 2008
Some Day You'll Pay The Price
I was concerned that the TARP plan would do little to free up credit. It does little to cleanse banks of their most toxic assets. Banks will not lend to other banks for (rightfully) fear that they may not be repaid. Investors will not buy non-GSE MBS due to the same fear. Now Treasury Secretary Paulson is revisiting an idea he had earlier discounted.
Mr. Paulson is considering making equity investments into troubled banks. This would have the immediate benefit of providing sorely needed Tier-1 capital. However, if it is similar to the treasury's handling of the GSEs, shareholders, common and preferred (non-cum preferred equity)may have cause for concern.
Many banks, including some of considerable size, are in trouble. Something must be done do head of massive failures. European governments have taken steps to make investments in banks or have seized them outright.
I do not see any positive developments for the equity or credit markets. Losses will need to be accounted for and the cleansing of balance sheets must occur to re-instill bank and investor confidence. This probably will not head off a recession.
The next casualties after banks may be the automakers. The Detroit Three (especially GM) may be too far gone to save. Do not be surprised if GM files for CH. XI protection soon.
Mr. Paulson is considering making equity investments into troubled banks. This would have the immediate benefit of providing sorely needed Tier-1 capital. However, if it is similar to the treasury's handling of the GSEs, shareholders, common and preferred (non-cum preferred equity)may have cause for concern.
Many banks, including some of considerable size, are in trouble. Something must be done do head of massive failures. European governments have taken steps to make investments in banks or have seized them outright.
I do not see any positive developments for the equity or credit markets. Losses will need to be accounted for and the cleansing of balance sheets must occur to re-instill bank and investor confidence. This probably will not head off a recession.
The next casualties after banks may be the automakers. The Detroit Three (especially GM) may be too far gone to save. Do not be surprised if GM files for CH. XI protection soon.
Wednesday, October 8, 2008
I'm Sorry For The Things I've Done
While reviewing my posts one fact keeps resurfacing. Although I was correct on the oil bubble and the damage to the financial system (it was far worse than even I thought), I poorly assessed the preferred securities situation. This is especially true of the preferred market.
My problem is that I was thinking logically. It appeared illogical that the government would do anything to make it more difficult for compamies to raise Tier-1 capital. Yet, this is exactly what it did when it blew up FRE and FNM preferred holders. It then blundered by acting inconsistently when dealing with troubled firms.
The markets abhor the illogical. Research analysts and strategists do a good job of taking data and formulating opinions. Government actions now require psychics instead of analysts to forecast the markets. Blowing up Lehman after engineering a shotgun wedding for Bear, but before taking over AIG has done that.
I can do a good job looking at the data and telling readers how certain investments shoudl react. However, I can not read the minds of Paulson and Bernanke. It would be helpful if they visited trading desks and financial advisers befoe further policy actions.
My problem is that I was thinking logically. It appeared illogical that the government would do anything to make it more difficult for compamies to raise Tier-1 capital. Yet, this is exactly what it did when it blew up FRE and FNM preferred holders. It then blundered by acting inconsistently when dealing with troubled firms.
The markets abhor the illogical. Research analysts and strategists do a good job of taking data and formulating opinions. Government actions now require psychics instead of analysts to forecast the markets. Blowing up Lehman after engineering a shotgun wedding for Bear, but before taking over AIG has done that.
I can do a good job looking at the data and telling readers how certain investments shoudl react. However, I can not read the minds of Paulson and Bernanke. It would be helpful if they visited trading desks and financial advisers befoe further policy actions.
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