Another Dozen Notes on Our Manic-Depressive Credit Markets
This is what I sometimes call a “Great Garbage Post.” I’ll cover a lot of ground, so bear with me.
1) How to do a bank/financial bailout: a) wipe out common and preferred equity and the subordinated debt (and offer some warrants to the debtholders). Make the senior debt take a haircut of 50% (and offer warrants), and the bank debt a haircut of 20% (and offer warrants). Capital is offered in exchange for the equity interest, together with some senior financing pari passu with the banks. If the management and other stakeholders do not like those terms (or something like them), then don’t bail them out.
Now, realize I’m not crazy about “lender of last resort” powers being in the hands of the government, but if we’re going to do that, you may as well do it right, and bail out depositors in full, while having others take modest to large haircuts. There is no reason why the government/Federal Reserve should bail out common or preferred equityholders, and those that bought risky debt should pay part of the price as well. This should only be done for institutions where significant contagion effects could affect other financial institutions. The objective is to create a firewall for depositors, and the rest of the financial system.
2) Bear Stearns. Ugh, a bank run. A testimony to leverage. Book value is only fair if one can realize the value over time. High leverage implies a haircut to book value in bad times, because the value of the assets can go down dramatically. Will they get a buyer? I don’t know, and I wouldn’t trust JC Flowers. If what Jamie Dimon might be thinking is what the Bloomberg article states, then I think he has the right idea: keep the best businesses, dissolve the rest.
But remember, during crises, highly levered financial institutions are vulnerable, unless most of their financing is locked in long-term. Most investment banks don’t fit that description, particularly with all of the synthetic leverage in their derivative books.
3) The downgrades on commercial bank credit ratings will continue to come, particularly for those that were too aggressive in lending to overlevered situations, e.g., home equity lending. Home equity lending is very profitable in good times, but then it gets overcompetititive, and underwriting standards deteriorate. Then a lot of money gets lost, as in 1998, where most of the main lenders went under. In this case, most of the lenders are banks, and they aren’t concentrated in that line alone.
4) Home builders are taking it on the chin. Consider this article about joint venture failures of homebuilders. It is my guess that we will see a few of the major homebuilders fail. It will take us to 2010 to reconcile all of the excess inventory. Personally, I would guess that the stable home ownership rate is still below the current level by maybe 2% of the households. We tried to force homeownership on people that were not ready for it, people who didn’t have enough financial slack to make it through even a slight recession.
5) I find it amusing that Bob Rubin, the only guy in the Clinton Administration that I liked, says that few people anticipated this bubble. (Sounds like Greenspan, huh?) Well, in a sense he’s right. Probably fewer than 1% of Americans anticipated these results, but there were enough writers in the blogosphere that were saying that something like this would come (including me), that some could take warning. As in the tech bubble, there were a number of notable commentators warning, but no one listens during the self-reinforcing cycle of the boom.
6) I am sticking with a 50-75 basis point move from the Fed in the coming week. They want to move aggressively, but they don’t want to use up all of their conventional ammo, when they are so close to the “zero bound.” They might disappoint the markets, but not on purpose. They will tend to follow what the markets suggest.
7) This Fed is more willing to try novel solutions than in the Greenspan era. Even so, I expect them to run into constraints on their ability to deal with the crisis, which will force the Treasury Department (yes, even in the Bush Administration) to act.
8) The glory of “core inflation” is not that it excludes the most volatile classes of goods, but the ones for which there is the most excess demand. Food price inflation is running. Farmers can’t keep up with the demand. Poetic justice for the hard-working farmers of our country, who have had more than their share of hard years. Agriculture is one of the industries that makes America great. Let the rest of the world benefit from our productivity there.
9) This is one of those times where one can get a “pit in the stomach” from considering the possibilities from a financial crisis. As leverage dries up, those with the most leverage on overvalued asset classes get margin calls, leading to forced liquidations. As it stands now, many credit hedge funds are finding it difficult to maintain their leverage levels, and other hedge funds are finding their lending lines reduced. This forces a reduction in speculation, and the prices of speculative assets.
10) Be careful using the ABX indices. They are too easy to short, and do not represent the values that are likely to be realized in the cash markets. The same is true of the CMBX indices. This would lead me to be a bull, selectively, in AAA CMBS, after careful analysis of the underlying collateral. (CMBS was a specialty of minewhen I was a mortgage bond manager.)
11) Two interesting articles on character and capitalism. This is a topic that I havea lot to say about, but every time I sit down to write about it, I am not satisfied with the results. Let me make a down payment on an article here. Capitalism is good, but Capitalists often abuse it. Short-sighted capitalists play for short-term advantage, and end up burning up relationships. Longer-term capitalists play fair, because they not only want deal one, but deals two, three, four, etc. They play fair because they will do better in the long run, even if they are intelligent pagans. (Christians should play fair anyway, because their Father in heaven looks at their deeds. If we love Him, we will please Him.)
Economics isn’t everything. Smart businessmen know that a good reputation is golden. They also know that happy employees are more productive. Suppliers that get paid on time are more loyal. These are the benefits of ethical, long-run thinking.
12) In closing, a poke at quantitative analysis done badly. Consider Paul Wilmott, or William Shadwick. With bosses over the years, often they would ask me a seemingly simple quantitative question, and I would reply, “Here’s the standard answer: XXXXX. But there are many reasons why that answer could be wrong, because the math makes too many assumptions about market liquidity, investor rationality, soundness of funding sources, etc.” Most quants don’t know what they are assuming. They are too good with the math, and not good enough at the human systems that inadequately lie behind the math.
As a quantitative analyst, I have generally been a skeptic. At times like this, when the assumptions are breaking down, it gives me a bit of validation to see the shortfall. That said, it’s no fun to be right when you are losing money, even if it is less than others are losing.
