This past weekend, Barron's published two articles pertaining to the government's involvement in the banks. One article discussed the advantage of buying non-cumulative preferreds instead of common equity as a speculation for possible gains should the bank in question recover from the current financial crisis. That part of the article makes sense. With some of these non-cumulative preferreds selling at between 35 and 50 cents on the dollar and yields near or above 20%, non-cumulative preferreds may be a viable alternative to common equity. The article drifts off base after that.
The article repeats the Bill Gross mantra that if the government owns preferred shares, investors are protected by investing along side the government. With the government investing at the preferred level because it had to, to increase banks' Tier-1 capital (not because it wanted to) and giving itself a cumulative feature, having the government along side you is like going into business with the mob assuming that the local don will treat you as he treats himself when the operation goes south. When one invests at the preferred stock level, one is a part owner of the company and not a creditor. When things get tough, creditors get paid (hopefully) at the expense of owner distributions. This is not to say that preferred stock dividends will not be paid, but why take the risk? At least get to the trust preferred level to become a creditor. Hope that the government will take care of you because it owns preferreds (which the dividend is a drop in the bucket when considering government dollars) is not a strategy.
The other article discussed how further government assistance for banks to could favor depositors over investors. The article suggests that troubled banks could be restructured in a way in which investors, even bond investors are not made whole. The funny thing is, only one person mentioned this article. After all, this is a negative article. This is a case of seeing what one wants to see.
This article may not be any more correct than the positive article about preferreds, nut it may not be any more incorrect. My point is that this is the most severe financial crisis since the 1930s. The implications of government and private sector policies and actions should not be taken lightly.
GM and Chrysler could be subject to a government restructuring. If that ends up being the case it is very possible that the government forces investors, even senior bond investors, to accept less than 100 cents on the dollar. Bloomberg News reported today that government lawyers are working to ensure that the government has the top claim with regard to compensation in a restructuring of the auto makers. Invest along side the government? Right.
The Associated Press published an article about the latest bank rescue scheme and the plan to purchase bad assets from the banks which includes opinions and comments from various market participants. They comments are not dissimilar from what I have written previously. Take a gander:
"The first loss has got to be the government's," said Wall Street veteran Muriel Siebert, who runs the brokerage Muriel Siebert & Co. "Maybe the first 25 percent of losses. We don't know what's in some of those bonds."
"Billionaire Wilbur Ross, who runs the private equity firm WL Ross & Co., said investors want to know how much risk the government will accept if the investments go sour, and how much money the government is willing to put up — likely in the way of low-interest loans."
"And any sort of financing is something I would be interested in," said Jeffrey Gundlach, chief investment officer of Los Angeles-based money management firm The TCW Group. "There are distressed assets that I would like to buy now but I can hardly get anyone to lend me any money in the current environment."
"I want to see the incentives and the restrictions," said Jacob Benaroya, managing partner of New Jersey-based Biltmore Capital Group, a hedge fund that's buying up to $100 million in mortgage debt per year. For example, he said, he's unlikely to be interested in buying loans that must be held for 30 years.
"Investors want to know more about what those guarantees will be. Stephen L. Nesbitt, whose firm Cliffwater LLC advises clients considering alternative investments, said people want returns of about 20 percent before they will buy into really risky, distressed debt."
"They need help from the government to get there," Nesbitt said. "Either by increasing the return or decreasing the risk."
"Why would anyone want to buy these assets at inflated prices?" said Bill Fleckenstein, a Seattle-based hedge fund manager. "There's this argument that the banks can't sell at market prices because the market price is depressed. Well, that's what the market price is.""
"Lynn Tilton of the private equity firm Patriarch Partners said she wants to know what the government will consider a "bad asset" under this deal. There has to be some effort to find a real value, she said."
There you have it. Investors may consider buying troubled assets, if the government limits losses, provides cheap financing and they want to buy at fire sale prices. Simple eh? Godspeed Mr. Geithner.
Monday, February 9, 2009
Thursday, February 5, 2009
Fuggeddaboudit!
The story of the strong-arming of Bank of America CEO Ken Lewis by Fed Chairman Bernanke and former Treasury Secretary Paulson is quite disturbing. Apparently, Mr. Lewis and his time at Bank of America realized in Decemeber that the losses on toxic assets aT Merrill Lynch far exceeded what was expected. Although Mr. Lewis and his team could be blamed for not doing the best job of due dilligence, once the true extent of Merrill's toxic assets were known, efforts were made to abandon the deal. Enter Heavy Hank and Big Benny.
Mr. Lewis informed Mr. Paulson and Mr. Bernanke that he was considering pulling out of the deal to acquire Merrill. This was of great concern to Hank and Benny. After all, if Merrill failed, life would become very difficult for them and for the financial system. What followed could have come straight from the Sopranos.
Mr, Bernanke and Mr. Paulson first tried to reason with Mr. Lewis by pointing out that investors could have negative opinions of he and his firm. When he still balked at following through on the deal, Hank and Benny stated that if did not follow through with the acquisition of Merrill, TARP money could be scarce should Bank of America needed down the road. I spent my youth in Brooklyn. I can picture it.
Hank: Gee Ken, that's a nice bank you have here. It would be a shame if something happened to it.
Benny: You know: money is tight. It oculd be bad for you of there wasn't any left. We're not threatening. We're just saying.
We all know that the financial crisis is dire. Moody's announced today that it is going to review over $300 billion of commercial mortgage-backed securities for possible downgrades. This could be the other shoe dropping for the banks. Maybe the country would be better off if the government would acknowldege that troubled assets on bank balance sheets are going to lead to losses and decide who is going to take them, the banks or the taxpayers. However, in typical Washington fashion, the government continues to look for ways to deal with the losses with no one taking responsibility. Not going to happen. We have a nice country here. It would be a shame if something happened to it.
Mr. Lewis informed Mr. Paulson and Mr. Bernanke that he was considering pulling out of the deal to acquire Merrill. This was of great concern to Hank and Benny. After all, if Merrill failed, life would become very difficult for them and for the financial system. What followed could have come straight from the Sopranos.
Mr, Bernanke and Mr. Paulson first tried to reason with Mr. Lewis by pointing out that investors could have negative opinions of he and his firm. When he still balked at following through on the deal, Hank and Benny stated that if did not follow through with the acquisition of Merrill, TARP money could be scarce should Bank of America needed down the road. I spent my youth in Brooklyn. I can picture it.
Hank: Gee Ken, that's a nice bank you have here. It would be a shame if something happened to it.
Benny: You know: money is tight. It oculd be bad for you of there wasn't any left. We're not threatening. We're just saying.
We all know that the financial crisis is dire. Moody's announced today that it is going to review over $300 billion of commercial mortgage-backed securities for possible downgrades. This could be the other shoe dropping for the banks. Maybe the country would be better off if the government would acknowldege that troubled assets on bank balance sheets are going to lead to losses and decide who is going to take them, the banks or the taxpayers. However, in typical Washington fashion, the government continues to look for ways to deal with the losses with no one taking responsibility. Not going to happen. We have a nice country here. It would be a shame if something happened to it.
Tuesday, February 3, 2009
Mythbusters
During the past two days, there have been two articles, one in the Wall Street Journal and one on Bloomberg News discussing so-called "hybrid securities" The mention of hybrids has causes some investors to believe that the articles were referring to trust preferreds or even straight preferred equity. Let's cut through the haze.
Let's discuss the Wall Street Journal article. After reading it twice, it made little sense to me. The author first makes reference to the $700 billion hybrid market. That would have to include the trust preferreds. However, the relevance to the $25 par preferreds with which we are familiar ends here. The author mentions investor dismay that these hybrids were not retired "when expected" Since he mentioned perpetual hybrids, this posed two questions: 1) Since most $25 trust preferreds (hybrids) have maturities, what his he talking about? 2) If they are perpetual the only way they can be retired is by the issuer calling them in. Fixed income 101 states that one should never count on a call be exercised. Fixed income 205 says that an issuer will only call a security if doing so is advantageous for the issuer. Given the current credit markets environment, I could not imagine an issuer finding an advantage of calling in a security unless its coupon was so high that refinancing at today's rates offered a cost savings. My curiosity got the best of me so I contacted the author, Neil Shah or the Wall Street Journal.
Mr. Shah was happy to answer my e-mails, but what he told me made me concerned that those reporting on more esoteric securities have little understanding of their markets. The first thing I did was ask Mr. Shah to offer an example of a hybrid security which investors expected to be called. They security he used as an example as a Deutsche Bank 1,000 euro perpetual hybrid (yes, it is euro denominated), 3.875% due 2014. My eyes nearly popped out of my head. How could anyone in their right minds believe that a bank which would need to offer a five-year bond of at least 6.00%, if not higher, in today's environment call in a hybrid with a 3.875% coupon? Mr. Shah insists that investors expected this security and others like it to be called. My colleagues and I would be anxious to be the other side of these investors' trades. We could probably make a nice living this way, albeit for a short period of time as they would soon run out of capital. Mr. Shah also insisted that similar securities (with similar coupons) have been called in during the past year. Skeptical, we looked into this. We could not find an example. Mr. Shah couldn't or wouldn't offer examples. This myth was busted.
Today, Bloomberg News discussed hybrids. Although the securities discussed by Bloomberg are more closely related to the more familiar $25 trust preferreds, the article was about a different kind of structure.
The Bloomberg article discussed how hybrid securities may stop paying interest if a bank was nationalized. The securities being referred to are $1,000 trust securities. These are essentially trust preferreds which trade and look like corporate bonds. As with $25 trust preferreds, they are kinds of junior subordinate debt. The article is correct that in the case of a nationalization, hybrid interest payments could be stopped. They could be stopped permanently. They could be stopped temporarily. However, this could be true of straight preferreds (non-cumulative preferred equity), common shares and even senior debt.
In the case of a nationalization, the government could force what is known as a cram down. A cram down results in investors receiving less than par for their securities. The more senior one's securities are, the more one will receive. In the case of a cram down, investors have little recourse but to take what they get. Trust securities will always fair better than common and preferred equity and will always fair worse than more senior debt. The article was right to express concern over the treatment of trust securities in the case of a nationalization, but it should have mentioned that more subordinate securities are even more vulnerable.
The Bloomberg article, although not really false, appeared to foster a myth that hybrids were especially vulnerable to a nationalization. In actuality, non-cumulative preferred equity and common shares are even more vulnerable and even senior debt is may not be immune. The bottom line is that if one thinks that a true nationalization is possible for a bank, one should look elsewhere for investment opportunities. Although the nationalization of troubled banks is possible, it is an action of last resort as it would be expensive and cumbersome to seize a large bank. I would have to say that the myth that hybrids are an especially vulnerable asset class has been busted.
Let's discuss the Wall Street Journal article. After reading it twice, it made little sense to me. The author first makes reference to the $700 billion hybrid market. That would have to include the trust preferreds. However, the relevance to the $25 par preferreds with which we are familiar ends here. The author mentions investor dismay that these hybrids were not retired "when expected" Since he mentioned perpetual hybrids, this posed two questions: 1) Since most $25 trust preferreds (hybrids) have maturities, what his he talking about? 2) If they are perpetual the only way they can be retired is by the issuer calling them in. Fixed income 101 states that one should never count on a call be exercised. Fixed income 205 says that an issuer will only call a security if doing so is advantageous for the issuer. Given the current credit markets environment, I could not imagine an issuer finding an advantage of calling in a security unless its coupon was so high that refinancing at today's rates offered a cost savings. My curiosity got the best of me so I contacted the author, Neil Shah or the Wall Street Journal.
Mr. Shah was happy to answer my e-mails, but what he told me made me concerned that those reporting on more esoteric securities have little understanding of their markets. The first thing I did was ask Mr. Shah to offer an example of a hybrid security which investors expected to be called. They security he used as an example as a Deutsche Bank 1,000 euro perpetual hybrid (yes, it is euro denominated), 3.875% due 2014. My eyes nearly popped out of my head. How could anyone in their right minds believe that a bank which would need to offer a five-year bond of at least 6.00%, if not higher, in today's environment call in a hybrid with a 3.875% coupon? Mr. Shah insists that investors expected this security and others like it to be called. My colleagues and I would be anxious to be the other side of these investors' trades. We could probably make a nice living this way, albeit for a short period of time as they would soon run out of capital. Mr. Shah also insisted that similar securities (with similar coupons) have been called in during the past year. Skeptical, we looked into this. We could not find an example. Mr. Shah couldn't or wouldn't offer examples. This myth was busted.
Today, Bloomberg News discussed hybrids. Although the securities discussed by Bloomberg are more closely related to the more familiar $25 trust preferreds, the article was about a different kind of structure.
The Bloomberg article discussed how hybrid securities may stop paying interest if a bank was nationalized. The securities being referred to are $1,000 trust securities. These are essentially trust preferreds which trade and look like corporate bonds. As with $25 trust preferreds, they are kinds of junior subordinate debt. The article is correct that in the case of a nationalization, hybrid interest payments could be stopped. They could be stopped permanently. They could be stopped temporarily. However, this could be true of straight preferreds (non-cumulative preferred equity), common shares and even senior debt.
In the case of a nationalization, the government could force what is known as a cram down. A cram down results in investors receiving less than par for their securities. The more senior one's securities are, the more one will receive. In the case of a cram down, investors have little recourse but to take what they get. Trust securities will always fair better than common and preferred equity and will always fair worse than more senior debt. The article was right to express concern over the treatment of trust securities in the case of a nationalization, but it should have mentioned that more subordinate securities are even more vulnerable.
The Bloomberg article, although not really false, appeared to foster a myth that hybrids were especially vulnerable to a nationalization. In actuality, non-cumulative preferred equity and common shares are even more vulnerable and even senior debt is may not be immune. The bottom line is that if one thinks that a true nationalization is possible for a bank, one should look elsewhere for investment opportunities. Although the nationalization of troubled banks is possible, it is an action of last resort as it would be expensive and cumbersome to seize a large bank. I would have to say that the myth that hybrids are an especially vulnerable asset class has been busted.
Sunday, February 1, 2009
Into The Great Wide Open
Benanke and Co. are not addressing the core problem. The core problem is not the GSE qualifying mortgages which the Fed is buying in securities form (along with GSE debt). It is the so-called jumbo mortgages (original balances over $417,000) which are problems. Many of these mortgages are for homes purchased at the peak of the bubble. They cannot be refinanced via a Freddie, Fannie or Ginnie mortgage. Banks are very careful about to whom they lend above the GSE limits because it is very difficult to securitize these mortgages because, unlike GSE MBS in which the investors' principal is guaranteed by the GSEs, a so-called private label MBS is backed ONLY by the underlying mortgages. If they fail, you fail.
There is a populist movement which wants the banks to hold mortgages so that they will have "skin in the game" like in the old days. This sounds good on Main Street, but by going this route, even responsible borrowers would not be able to obtain mortgages. Even the largest banks would soon run out of lending capital. If bank used corporate bonds of covered bonds (corporates backed by a pool of mortgages), these bonds would be counted as debt on corporate balance sheets. To maintain acceptable Tier-I Capital ratios, banks would need billions of deposits or equity or preferred IPOs. Not going to happen except from the government (I.E. the TARP preferreds).
Even with the banks "leveraged gone wild" period considered, the damage to the economy need not have gotten this severe. If home prices were permitted to adjust (fall) to levels based on supply and demand early in 2008, we may have seen a recovery by now. What happened instead were several half measures to keep people in homes who could not afford to keep them and a push to refinance mortgages with balances higher than the homes true worth (as opposed to bubble value). These half measures kept home buyers out of the market as the waited for home prices to fall, believing (correctly) that the government would only make things worse.
The result has been a long slow bleed of home prices. This long slow bleed has eroded consumer confidence, reduced consumer spending and has caused the broader, even global, economy to sputter and stall (decoupling my butt). This has removed more potential home buyers from the market. The reduced demand from fewer potential home buyers promises to push home prices even lower. Now we are in a negative feedback loop. Home prices continue to fall, consumer confidence falls. layoffs mount and more home owners, even those who acted responsibly, fall behind on their mortgage payments as they lose their jobs.
Are home prices artificially low? Not according to the data. In many markets home prices are only approaching the pre-bubble levels of 2004 (Bloomberg News). This looks like a correction to me. However, Main Street and the politicians who pander to it believe that home prices should be immune from price cycles. Sorry folks, homes are commodities just like anything else. Their prices rise and fall for a number of reasons. Any attempts to interfere with market forces will be more harmful than helpful.
A few weeks back I discussed LIBOR-based floaters. Some concerns I had with the strategy of purchasing such preferreds was that their mechanics (how they trade and why) and where LIBOR was going and why were not understood. One of my concerns was that the TED spreads (spread between three-month LIBOR and the Three-month T-Bill will would narrow by the three-month LIBOR rate falling. This is what happened. As of Friday January 30th, three month LIBOR was down to 1.18% The TED spread, although still wider than normal (normal is 20 to 30 basis points). Current spread is about 95 basis points. With the Fed stating last week that it is going to keep the Fed Funds rate at or near zero for an extended period of time, I expect the TED spread to continue to narrow by three-month LIBOR rates falling. After all, one of the Fed's goals, as stated last year after Bear Stearns imploded, was to improve interbank lending.
Some investors may be saying: "So what, these preferreds have coupon floors." Although that is correct, the deeper LIBOR sinks, the more of an upward move in short-term is needed to get off of that floor. Also, in theory, the deeper LIBOR sinks and the further below the floor the raw coupon calculation gets, the cheaper these floaters should trade. Even if they don't sink much more, they sure as heck shouldn't rise in value (unless of course, investors who don't understand floaters come in and buy). I would wait a bit longer before jumping in to the floaters. LIBOR should fall a bit more.
One other aspect of these LIBOR based floaters of which investors should be aware. They are all preferred equity and rank below all debt and are equal to the government's TARP preferreds on the capital structure. Of course unlike publicly-traded preferred stocks, the government gave itself a cumulative feature.
Some investors question the advantages of moving only one step higher on the capital structure, from a traditional preferred to a trust preferred. In reality it is more than one step.
As a trust preferred holder one is a creditor of said company. As very junior creditor, but a creditor nonetheless. As a preferred stock holder, you are a part owner of the company. The differences in investor classes can be distinguished in terms of a small business.
Let's say "Joe" owns a small business. Joe needs money so I invest in his firm to the tune of a 10% investment. I now own 10% of Joe's company. A few months later, Joe needs more money so he gets a loan from the bank. Later that year, Joe's company is barely breaking even. He has a choice to pay me a distribution (dividend) of make payments on his bank loan. Obviously the bank gets paid instead of me. The bank is a creditor and deserves to be paid regardless of profitability. I am a part owner, I should only be paid out of profits. This is the big difference.
There is a populist movement which wants the banks to hold mortgages so that they will have "skin in the game" like in the old days. This sounds good on Main Street, but by going this route, even responsible borrowers would not be able to obtain mortgages. Even the largest banks would soon run out of lending capital. If bank used corporate bonds of covered bonds (corporates backed by a pool of mortgages), these bonds would be counted as debt on corporate balance sheets. To maintain acceptable Tier-I Capital ratios, banks would need billions of deposits or equity or preferred IPOs. Not going to happen except from the government (I.E. the TARP preferreds).
Even with the banks "leveraged gone wild" period considered, the damage to the economy need not have gotten this severe. If home prices were permitted to adjust (fall) to levels based on supply and demand early in 2008, we may have seen a recovery by now. What happened instead were several half measures to keep people in homes who could not afford to keep them and a push to refinance mortgages with balances higher than the homes true worth (as opposed to bubble value). These half measures kept home buyers out of the market as the waited for home prices to fall, believing (correctly) that the government would only make things worse.
The result has been a long slow bleed of home prices. This long slow bleed has eroded consumer confidence, reduced consumer spending and has caused the broader, even global, economy to sputter and stall (decoupling my butt). This has removed more potential home buyers from the market. The reduced demand from fewer potential home buyers promises to push home prices even lower. Now we are in a negative feedback loop. Home prices continue to fall, consumer confidence falls. layoffs mount and more home owners, even those who acted responsibly, fall behind on their mortgage payments as they lose their jobs.
Are home prices artificially low? Not according to the data. In many markets home prices are only approaching the pre-bubble levels of 2004 (Bloomberg News). This looks like a correction to me. However, Main Street and the politicians who pander to it believe that home prices should be immune from price cycles. Sorry folks, homes are commodities just like anything else. Their prices rise and fall for a number of reasons. Any attempts to interfere with market forces will be more harmful than helpful.
A few weeks back I discussed LIBOR-based floaters. Some concerns I had with the strategy of purchasing such preferreds was that their mechanics (how they trade and why) and where LIBOR was going and why were not understood. One of my concerns was that the TED spreads (spread between three-month LIBOR and the Three-month T-Bill will would narrow by the three-month LIBOR rate falling. This is what happened. As of Friday January 30th, three month LIBOR was down to 1.18% The TED spread, although still wider than normal (normal is 20 to 30 basis points). Current spread is about 95 basis points. With the Fed stating last week that it is going to keep the Fed Funds rate at or near zero for an extended period of time, I expect the TED spread to continue to narrow by three-month LIBOR rates falling. After all, one of the Fed's goals, as stated last year after Bear Stearns imploded, was to improve interbank lending.
Some investors may be saying: "So what, these preferreds have coupon floors." Although that is correct, the deeper LIBOR sinks, the more of an upward move in short-term is needed to get off of that floor. Also, in theory, the deeper LIBOR sinks and the further below the floor the raw coupon calculation gets, the cheaper these floaters should trade. Even if they don't sink much more, they sure as heck shouldn't rise in value (unless of course, investors who don't understand floaters come in and buy). I would wait a bit longer before jumping in to the floaters. LIBOR should fall a bit more.
One other aspect of these LIBOR based floaters of which investors should be aware. They are all preferred equity and rank below all debt and are equal to the government's TARP preferreds on the capital structure. Of course unlike publicly-traded preferred stocks, the government gave itself a cumulative feature.
Some investors question the advantages of moving only one step higher on the capital structure, from a traditional preferred to a trust preferred. In reality it is more than one step.
As a trust preferred holder one is a creditor of said company. As very junior creditor, but a creditor nonetheless. As a preferred stock holder, you are a part owner of the company. The differences in investor classes can be distinguished in terms of a small business.
Let's say "Joe" owns a small business. Joe needs money so I invest in his firm to the tune of a 10% investment. I now own 10% of Joe's company. A few months later, Joe needs more money so he gets a loan from the bank. Later that year, Joe's company is barely breaking even. He has a choice to pay me a distribution (dividend) of make payments on his bank loan. Obviously the bank gets paid instead of me. The bank is a creditor and deserves to be paid regardless of profitability. I am a part owner, I should only be paid out of profits. This is the big difference.
Wednesday, January 28, 2009
Who'll Stop The Rain
To no one's surprise, the FOMC left the Fed Funds rate unchanged. After all, the Fed Funds target rate is essentially zero (in a range between 0.00% and 0.25%). However, its statement indicates more economic trouble may lie ahead. In it's previous statement, the FOMC described credit as being tight. Today it described credit as being "extremely tight". This is not what was hoped four months into the TARP rescue plan.
The FOMC stated that the Fed will continue to buy MBS and agency debt and is "prepared to by longer-term Treasury securities" if such action is warranted. If the Fed does in fact begin buying long-term treasuries, that could help to keep long-term rates in check. However, at some point, possible a year or two from now, the supply of new bonds and renewed investor appetite for higher returns and stronger currencies are likely to push long-term treasury yields higher. This could also push commodities prices higher.
Will credit yields follow long-term treasury yields higher? Possibly, but there could be a crowding out effect. If investors believe they are being adequately compensated (I.E. the are happy) with higher yields on U.S. treasuries, corporations could be crowded out of the debt market. They would either have to raise their yields high enough to attract investors or find other means of funding. With credit spreads among some names and sectors at or near historical wides. some spread tightening is possible, even probable, but it may not entirely offset the rise of interest rates. I am one who believes that investors should underweight the long end of both the yield curve and credit curve at this time.
Bank stocks and bonds received a boost today after the government moved close to creating a so-called "bad bank" to take troubled assets off of bank balanced sheets. It is interesting how the equity markets become giddy without considering how bad assets would leave bank balance sheets.
Just because banks will be able to rid their balance sheets of bad assets does not mean they will not take more losses. It is unlikely (and foolish) for the government to purchase bad assets at inflated levels. That would guarantee losses for taxpayers (the RTC of the early 90s was a money loser). What it would do is eliminate further downside risk for the banks down the road. However, as some banks have not marked down assets to levels at which they can be sold, even to the government. Some banks have placed assets in the so-called Level III Asset bucket. This bucket is for assets which cannot be marked accurately (according to the owning bank) and have not been marked. Although the bad bank would increase transparency, troubled prophecies could be fulfilled as troubled banks will merely realize losses and end up being seized, nationalized or broken up. Remember, even the RTC permitted troubled S&Ls to fail. Positives came from the RTC's ability to calm fears that healthy banks may be holding on to troubled loans. The weaker banks may not come out of this unscathed.
I have previously mentioned that depressed prices of troubled assets is not just a mark-to-market phenomenon. As homes are foreclosed upon and auctioned off, these previously unrealized losses become realized. There was an article today on Bloomberg which discussed foreclosed properties selling for about 50 cents on the dollar at auction. Of course a spokesman for a consumer advocacy group derided these actions for lowering home values and making things more difficult for homeowners looking to refinance. It is high time that the public, advocates and government officials learn that a commodity or asset is only worth what someone is willing to pay for it. It is quite possible that one's $350,000 home is only worth $175,000.
The purpose of this piece is not to cast a pall over government efforts. I actually believe that a bad bank, RTC-like arrangement will keep most financial institutions intact and prevent nationalization of the banks. I do not believe that it will make all banks instantly healthy. There are some institutions which are sufficiently troubled that they may need more drastic intervention.
This brings us back preferreds (again). I do not believe that preferred dividends will be suspended,even preferred equity dividends of large, but troubled banks. However, it is not an impossibility. Why reach for 17% yield which could be wiped out by the government (for political as well as economic reasons), when one can earn 12% to 14% and be ahead of the government? What about non-cumulative preferreds trading at over 20%? These must be considered speculative investments at this time.
Those looking for a good explanation of trust preferreds should go here:
http://www.leggmason.com/privateclient/pdf/frcs.pdf
The FOMC stated that the Fed will continue to buy MBS and agency debt and is "prepared to by longer-term Treasury securities" if such action is warranted. If the Fed does in fact begin buying long-term treasuries, that could help to keep long-term rates in check. However, at some point, possible a year or two from now, the supply of new bonds and renewed investor appetite for higher returns and stronger currencies are likely to push long-term treasury yields higher. This could also push commodities prices higher.
Will credit yields follow long-term treasury yields higher? Possibly, but there could be a crowding out effect. If investors believe they are being adequately compensated (I.E. the are happy) with higher yields on U.S. treasuries, corporations could be crowded out of the debt market. They would either have to raise their yields high enough to attract investors or find other means of funding. With credit spreads among some names and sectors at or near historical wides. some spread tightening is possible, even probable, but it may not entirely offset the rise of interest rates. I am one who believes that investors should underweight the long end of both the yield curve and credit curve at this time.
Bank stocks and bonds received a boost today after the government moved close to creating a so-called "bad bank" to take troubled assets off of bank balanced sheets. It is interesting how the equity markets become giddy without considering how bad assets would leave bank balance sheets.
Just because banks will be able to rid their balance sheets of bad assets does not mean they will not take more losses. It is unlikely (and foolish) for the government to purchase bad assets at inflated levels. That would guarantee losses for taxpayers (the RTC of the early 90s was a money loser). What it would do is eliminate further downside risk for the banks down the road. However, as some banks have not marked down assets to levels at which they can be sold, even to the government. Some banks have placed assets in the so-called Level III Asset bucket. This bucket is for assets which cannot be marked accurately (according to the owning bank) and have not been marked. Although the bad bank would increase transparency, troubled prophecies could be fulfilled as troubled banks will merely realize losses and end up being seized, nationalized or broken up. Remember, even the RTC permitted troubled S&Ls to fail. Positives came from the RTC's ability to calm fears that healthy banks may be holding on to troubled loans. The weaker banks may not come out of this unscathed.
I have previously mentioned that depressed prices of troubled assets is not just a mark-to-market phenomenon. As homes are foreclosed upon and auctioned off, these previously unrealized losses become realized. There was an article today on Bloomberg which discussed foreclosed properties selling for about 50 cents on the dollar at auction. Of course a spokesman for a consumer advocacy group derided these actions for lowering home values and making things more difficult for homeowners looking to refinance. It is high time that the public, advocates and government officials learn that a commodity or asset is only worth what someone is willing to pay for it. It is quite possible that one's $350,000 home is only worth $175,000.
The purpose of this piece is not to cast a pall over government efforts. I actually believe that a bad bank, RTC-like arrangement will keep most financial institutions intact and prevent nationalization of the banks. I do not believe that it will make all banks instantly healthy. There are some institutions which are sufficiently troubled that they may need more drastic intervention.
This brings us back preferreds (again). I do not believe that preferred dividends will be suspended,even preferred equity dividends of large, but troubled banks. However, it is not an impossibility. Why reach for 17% yield which could be wiped out by the government (for political as well as economic reasons), when one can earn 12% to 14% and be ahead of the government? What about non-cumulative preferreds trading at over 20%? These must be considered speculative investments at this time.
Those looking for a good explanation of trust preferreds should go here:
http://www.leggmason.com/privateclient/pdf/frcs.pdf
Tuesday, January 27, 2009
Standing In The Shadows
Standing In The Shadows
Much has been made of the failure of the so-called Shadow Banking System. The question we are most asked regarding this topic is: What is the Shadow Banking System?
The Shadow Banking system consists of non-traditional financial entities which perform the lending functions of a bank. Some components of the Shadow Banking System are investment banks, SIVs, Hedge Funds, etc. These participants either provide financing by borrowing short-term and lending long-term or provide the necessary functions for other members to do so.
On the positive side, without the Shadow Banking System enabled more people to purchase homes and permitted the economy to grow as never before. On the negative side it resulted in lax lending standards, the abuse of credit and opaque risk and collateral exposure to investors. Some pundits the apparent demise of the Shadow Banking System. These pundits should be careful of what they wish for.
The problem does not lie with the idea of an alternative source of funding, but the abuses therein. Instead of the original intent of making borrowing easier and more affordable for qualified borrowers, the Shadow Banking System made it easy for non-deserving, unqualified borrowers obtain credit. The result of less-than-qualified borrowers obtaining mortgages is a record amount of delinquencies, defaults and foreclosures. The problem is moving from a market-to-market, unrealized loss problem, to a realized loss problem as banks either seize homes and sell them for what they can or make deals with homeowners to take whatever the home sells for and call it even with the borrower.
To what extent has the problem infected bank balance sheets? Even now, no one (except, maybe, for the banks themselves) is sure. The combination of the known problems in the housing market and the cloudy picture of bank balance sheets are frightening investors. Until investors are sufficiently confident to purchase uninsured corporate debt and private label (so-called jumbo) mortgage backed securities, which are only backed by the mortgage collateral and not whatsoever by the issuing bank, the housing market will be mired in its current morass.
The government has put itself on the hook for bank survival. Not only has it agreed to explicitly guarantee corporate TLGP bonds, but it has also purchased a preferred equity interest in the banks. The two actions are related. Because of Basel II banking requirements, the banks needed to raise Tier-I capital. Banks could not issued more debt (Tier-II capital) until Tier-I ratios were improved. This is why the government came in at the preferred equity level.
Investors should not consider a government investment at the preferred equity a vote of confidence, but an action of necessity. Advisers and clients should note that although the government’s preferreds are ranked equally with non-cumulative perpetual preferred equity, the so-called TARP preferreds are cumulative. The government gave itself some protection should it become necessary to have a bank (or banks) suspend dividends. If the government had a choice, it would have invested on the most senior place on bank capital structures, the senior secured debt level. However, that would have provided banks with Tie-II capital and not the much-needed Tier-I capital
Why would the government order a bank to suspend dividends? How about to fund operations and pay its debts? After all, a bank can suspend dividends and continue to function. However, if a bank cannot make its coupon payments or mature its debt and it is out of business and not a problem for the government. The problem is two-fold. First: the troubled bank becomes a problem for the FDIC. If that bank happens to be a large money center bank, the FDIC could be stressed to the point of fund depletion. Also, the government would now be responsible for the FDIC-backed TLGP bonds. The government would likely do anything it could not to get to this point.
Some pundits have suggested that investors buy what the government is buying. In other words, invest in the banks the government is backing. I agree with that when it comes to bonds (for reasons I have already mentioned), but not with preferreds. Since the government bought bank preferreds because it needed to do so to boost Tier-I capital ratios and not because it believed doing so was a wise investment and could and would suspend dividends if necessary, preferred investors should get above the government and purchase trust preferreds which, being junior subordinate debt, have a better chance of paying and are cumulative.
Advisers and investors should avoid swinging for the fences and play small ball. A single is better than a strike out.
Much has been made of the failure of the so-called Shadow Banking System. The question we are most asked regarding this topic is: What is the Shadow Banking System?
The Shadow Banking system consists of non-traditional financial entities which perform the lending functions of a bank. Some components of the Shadow Banking System are investment banks, SIVs, Hedge Funds, etc. These participants either provide financing by borrowing short-term and lending long-term or provide the necessary functions for other members to do so.
On the positive side, without the Shadow Banking System enabled more people to purchase homes and permitted the economy to grow as never before. On the negative side it resulted in lax lending standards, the abuse of credit and opaque risk and collateral exposure to investors. Some pundits the apparent demise of the Shadow Banking System. These pundits should be careful of what they wish for.
The problem does not lie with the idea of an alternative source of funding, but the abuses therein. Instead of the original intent of making borrowing easier and more affordable for qualified borrowers, the Shadow Banking System made it easy for non-deserving, unqualified borrowers obtain credit. The result of less-than-qualified borrowers obtaining mortgages is a record amount of delinquencies, defaults and foreclosures. The problem is moving from a market-to-market, unrealized loss problem, to a realized loss problem as banks either seize homes and sell them for what they can or make deals with homeowners to take whatever the home sells for and call it even with the borrower.
To what extent has the problem infected bank balance sheets? Even now, no one (except, maybe, for the banks themselves) is sure. The combination of the known problems in the housing market and the cloudy picture of bank balance sheets are frightening investors. Until investors are sufficiently confident to purchase uninsured corporate debt and private label (so-called jumbo) mortgage backed securities, which are only backed by the mortgage collateral and not whatsoever by the issuing bank, the housing market will be mired in its current morass.
The government has put itself on the hook for bank survival. Not only has it agreed to explicitly guarantee corporate TLGP bonds, but it has also purchased a preferred equity interest in the banks. The two actions are related. Because of Basel II banking requirements, the banks needed to raise Tier-I capital. Banks could not issued more debt (Tier-II capital) until Tier-I ratios were improved. This is why the government came in at the preferred equity level.
Investors should not consider a government investment at the preferred equity a vote of confidence, but an action of necessity. Advisers and clients should note that although the government’s preferreds are ranked equally with non-cumulative perpetual preferred equity, the so-called TARP preferreds are cumulative. The government gave itself some protection should it become necessary to have a bank (or banks) suspend dividends. If the government had a choice, it would have invested on the most senior place on bank capital structures, the senior secured debt level. However, that would have provided banks with Tie-II capital and not the much-needed Tier-I capital
Why would the government order a bank to suspend dividends? How about to fund operations and pay its debts? After all, a bank can suspend dividends and continue to function. However, if a bank cannot make its coupon payments or mature its debt and it is out of business and not a problem for the government. The problem is two-fold. First: the troubled bank becomes a problem for the FDIC. If that bank happens to be a large money center bank, the FDIC could be stressed to the point of fund depletion. Also, the government would now be responsible for the FDIC-backed TLGP bonds. The government would likely do anything it could not to get to this point.
Some pundits have suggested that investors buy what the government is buying. In other words, invest in the banks the government is backing. I agree with that when it comes to bonds (for reasons I have already mentioned), but not with preferreds. Since the government bought bank preferreds because it needed to do so to boost Tier-I capital ratios and not because it believed doing so was a wise investment and could and would suspend dividends if necessary, preferred investors should get above the government and purchase trust preferreds which, being junior subordinate debt, have a better chance of paying and are cumulative.
Advisers and investors should avoid swinging for the fences and play small ball. A single is better than a strike out.
Thursday, January 22, 2009
Good Times, Bad Times
In today's Wall Street Journal David Roche, president of Independent Strategy discusses how to deal with the banks toxic assets. He advocates setting up a bad bank to take on banks toxic assets. He describes what he calls a good-bad bank and a bad-bad bank. A good-bad bank would buy toxic assets at their market prices thereby punishing banks for their bad decisions, but instilling confidence among the public by creating transparency. No longer will investors and depositors worry about what lurks on balance sheets. Those weaker banks can either be recapitalized, nationalized or sold to other banks. A bad-bad bank would essentially absolve banks from their poor decision making and suspect risk management. However, either would permit the economy, asset prices and real estate prices to find a bottom. A bottom that politicians are trying to avoid, but which is necessary. As Mr. Roche states:
"As we saw in Japan in the 1990s, if the market is not allowed to clear, the financial crisis will be prolonged. Although debt deflation may be avoided, the economic recession will be longer and the recovery weaker."
This is something I have said, ad nauseum, for over a year. Politicians have chosen to ease borrowing costs to try and reignite the economy by re-leveraging. Mr. Roche is correct when he says that this could lead to more and larger bubbles. At some point, one must pay the piper.
Although banks may have to pay the piper, troubled banks may not pay dividends. The paying of dividends is how a company shares profit or revenues with its investors. This is as opposed to interest payments which must be made, whether or not a company is profitable. Although I do not believe that preferred stock dividends will be cut (unless in an extreme situation) for political reasons, I would rather own an interest-paying vehicle such as a trust preferred or, even better, a bond rather than a dividend-paying preferred stock which could have its dividend wiped out by either a lack of profits or revenues or for political reasons (the government forcing the issue due to a bank using TARP money to pay dividends).
"As we saw in Japan in the 1990s, if the market is not allowed to clear, the financial crisis will be prolonged. Although debt deflation may be avoided, the economic recession will be longer and the recovery weaker."
This is something I have said, ad nauseum, for over a year. Politicians have chosen to ease borrowing costs to try and reignite the economy by re-leveraging. Mr. Roche is correct when he says that this could lead to more and larger bubbles. At some point, one must pay the piper.
Although banks may have to pay the piper, troubled banks may not pay dividends. The paying of dividends is how a company shares profit or revenues with its investors. This is as opposed to interest payments which must be made, whether or not a company is profitable. Although I do not believe that preferred stock dividends will be cut (unless in an extreme situation) for political reasons, I would rather own an interest-paying vehicle such as a trust preferred or, even better, a bond rather than a dividend-paying preferred stock which could have its dividend wiped out by either a lack of profits or revenues or for political reasons (the government forcing the issue due to a bank using TARP money to pay dividends).
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