The Aleph Blog » 2008 » September

Archive for September, 2008

Back to One-Off Bailouts

Tuesday, September 30th, 2008

The House vote rejecting the Bailout bill leaves us where we were before: the Treasury, FDIC, Fed, and all the quasi-financial arms of the government do one-off bailouts as needed.  That may be better than the proposed  bailout for a number of reasons.

  • For raw reasons of liberty, it is good to keep the government reactive rather than proactive.
  • The bailout as proposed did not meet our most pressing needs.  Our biggest problems are in the short-term lending markets, and the bailout did not address that directly.
  • Doing triage on the banks, and recapitalizing the survivors (at a price) may have been the optimal strategy.  Why save non-regulated entities?
  • The prior actions of the Fed and Treasury aimed at the short-term lending markets.

My last piece on this topic was pessimistic.  I am still pessimistic, even as the Fed expands the dollar swap facilities, and the TAF.  The commerical paper market is shrinking.  People are fleeing Municipal Money Market Funds.  The repo market is freezing.  And, longer maturity investment grade credit is hurting as well.

There will be limits at some point, though.  Look at a scaled version of the asset side of the Fed’s balance sheet:

Now, the lowest quality assets of the Fed are in the middle of the graph. Also note that until the last month, total assets at the Fed were fairly constant. Now add in the expansion of the TAF.  Does the Fed decrease its holdings of Treasuries still further, or does the Treasury keep creating more Treasuries and give them to the Fed?

This game could continue on for a while.  The Treasury and Fed create credit using the balance sheet of the US Government and the Fed, and use it to bail out damaged lending markets.  And, as I measure it, that has already supplied $500 billion or so to the lending markets, with another $300 billion or so on the way.

My question: if the prior bailouts through the Fed have not worked, why should the proposed $700 billion bailout work, particularly when it is targeted at longer term assets of banks?

A couple of notes before I close:

  • This piece that Barry cites is a great read.  I have long felt that our nation as a whole blames its politicians too much, and does not blame itself enough.
  • Yesterday was my biggest percentage and dollar loss ever.
  • Adding insult to injury, I accidentally destroyed my main work computer by spilling juice on it.  My productivity has fallen.

What A Fine Mess You Have Gotten Us Into

Saturday, September 27th, 2008

One week ago, I posted Oppose The Treasury’s Bailout Plan.  Since then, most criticisms of Henry Paulson’s original proposal supposedly have been incorporated into the new compromise bill, including my criticisms.

But my concern at present is whether the bailout will work at all. I think the complexities of the reverse auctions on small illiquid distressed securitized assets will prove difficult.  Further, the talk that the baioout won’t cost anything is highly unlikely.  Of all of the US Government’s bailouts, only the Chrysler bailout made money.  So long as you are in a fiat money system, in a bailout, the job of the government is to prevent contagion and minimize loss, in that order.  Bailouts don’t make money, and that should not be expected.

But hey, if they are going to play for profit, let them play big.  I was joking around when I wrote my article 2300 Smackers, and I am joking a little here as well.  Why not use the $700 billion to capitalize 10 new banks with $70 billion of capital each?  Let them lever up 10:1 — you have $7 trillion of buying power.  Let the public participate along side the government and the power expands further.  With a profit motive, they will buy and finance what makes sense, and five years from now, the government would sell its stakes, and pay down debt.

The rough part is that they have a non-profit-oriented main shareholder, looking to bail out dodgy institutions.  Also, if the risk is smaller than $7 trillion, these institutions won’t do well.  Also, what of the financials who don’t have government sponsorship?  Couldn’t the government just take super-senior convertible bond stakes in institutions that are under duress?  (Oh, that sounds like one-off bailouts?  Could be a lot cheaper than the current plan…)

And what of the borrowing?  Can this be funded at reasonable yields, and with the dollar at current purchasing power levels?  I have my doubts, though the markets have been benign over the last few days.

Consider the actions of the Federal Reserve in concert with the Treasury.  As I pointed out in Entering the Endgame for Monetary Policy,there is a panic quality to the Fed’s actions.  This concept is endorsed by Brad Setser, Randall Forsyth, and Michael Panzner, among others.  With the short term money markets in disarray, we have Asian Central Banks cutting rates, which aids the West, but increases inflationary risk.

Three notes to close:

  • I don’t know what Monday will bring in entire, but a failure of Fortis seems likely.   Note that the ECB is not on the hook here but the Belgian central bank (which probably feeds into their Treasury).
  • What the FDIC did with WaMu affects other banks like Wachovia.  Bidders will let the holding company fail, and bid for the operating bank subsidiary assets.  Holders of holding company securities get hit, as their likelihood of getting reasonable recoveries disappears.
  • We are putting a lot of faith in the health of Citigroup, Bank of America, and JP Morgan.  If one of them fails, the game is over.  Given their complexity, and the recent takeovers, the odds of there being a significant mistake are high.  Consider further that they are counterparties for more than 50% of all derivative transactions, so the synthetic leverage is high as well.

All “solutions” to the crisis at this point in time are bad solutions.  The time to act was 10-15 years ago, where we could have implemented contra-cyclical policies in bank regulation, as well as enforcing a strict separation between regulated and nonregulated financial intermediaries.  (No ownership, no lending, no derivative agreements.)

I don’t know what next week will bring us.  Last week was bad for me on a relative performance basis.  My inclination is to look at companies that have good global demand, and not much debt.  As for bonds, keep them short, unless you are buying long TIPS.

My Time on the Ron Smith Show

Saturday, September 27th, 2008

This is not a political blog. (Repeat?!)  Ugh.  I’m tired.  Between my work today for a potential new client that will really kick off my business, and appearing on the Ron Smith show, I am bushed.

I found the time in the WBAL studios interesting.  I get how radio works now, for a successful show like Ron Smith’s.  We had a lot of fun conversations during the breaks, and I went home with some reading assignments, of things I have not read, but Ron thinks are important.  As I said before, he is a bright guy.

I was happy to spend an extra hour with Ron.  They cancelled their planned 5-6PM hour in order to talk more about the current economic troubles.  I was happy to do so.  I may have sounded more doom-and-gloom than I normally do, but it reflects the current conditions, which are tough.  I tried to describe the difficulties that the short-term lending markets are in, but our economy and society is complex.  It is difficult to explain in soundbites, and Ron gave me more time than most radio hosts would.

I made it through the two hours without any major flubs, though I do know I was asked to define M1, M2 and M3, but I forget; I think I got interrupted, so I never defined all of them.

One thing about live radio and TV, it goes fast, and it is stream-of-consciousness.  You can’t catch up on past thing that were inadequately handled.  You can only hit what the present caller is talking about.  As a generalist, perhaps I did well, because none of the callers gave me a hard time.  Ron, of course, was a gentleman, and was a big help to a neophyte trying to do his best.

I look forward to the next time I am on Baltimore’s most popular radio show.  I did much better than I expected. :D

Entering the Endgame for Monetary Policy

Friday, September 26th, 2008

x

Look at the H.4.1 report.  We may have finally hit the panic phase of monetary policy, where the Fed increases the monetary base dramatically.  They are pumping the “high-powered” money into loans:

  • $20 billion for Primary credit
  • $80 billion for Primary dealer and other broker-dealer credit
  • $70 billion for Asset-backed commercial paper money market mutual fund liquidity facility
  • $40 billion for Other credit extensions
  • $80 billion for Other Federal Reserve assets
  • -$20 billion netting out other entries

Making it an increase of roughly $270 billion from last week’s average to Wednesday’s daily balance.  Astounding.

In general, the increases are not being pumped into the banks, but into specialized programs to add liquidity to the lending markets.  Now, I’ve written about this before, but it bears repeating.  What happens if the Fed takes losses on lending programs.  It reduces the seniorage profits that they pay to the Treasury, which means the Treasury has to tax or borrow that much more.  The Fed isn’t magic; it’s a quasi-extension of the US Government in a fiat currency environment.  It’s balance sheet is tied to the US Treasury.

Yves Smith at Naked Capitalism is correct.  The US is no longer a AAA credit, particularly if you measure in terms of future purchasing power of US dollars.  I’ve felt that for years, though, with all of the unfunded future promises that the US Government has made with Medicare, Social Security, etc.  The credit of the US Government hinges on foreign creditors (like OPEC and China) to keep it going.  What will they offer them? The national parks? :(

I try to be an optimistic guy and hope for the best.  But the current actions of the government are making me think about a massive re-alignment of my portfolio… and I never do things like that.  But, if the government is ramming through desperate measures, maybe I should too.

On WBAL Radio

Friday, September 26th, 2008

I have long admired The Ron Smith Show, which I believe is the most listened-to radio show in Baltimore.  I will be on the show tomorrow starting at 4:05-15 Eastern Time.  You can find the live stream here (look top left).  I find this a real honor, because unlike most radio talk show hosts, Ron Smith is a genuinely bright guy, and doesn’t care about wider popularity.  Like me, he doesn’t care whether the broader society follows him or not.

2300 Smackers

Friday, September 26th, 2008

We’re talking stimulus, right?  And we trust the American People, right?  Why not just send each American household $2,300 for each man, woman, and child there?  Let them decide how the $700 billion stimulus should be used.  What, you say, it should diminsh debt?  But our dear government is doing nothing of the kind.  They are borrowing massively from China and OPEC.

What’s that, you say?  That doesn’t help the banks?  Well, why help the banks unless it helps the people?  So why not help the people directly, and maybe it will help the banks.  You believe in the free market, which means individual choice, right?

Sigh.  Our government believes nothing like this.  They intervene to protect their patrons, the financial institutions, while dissing the taxpayers, and that is how it goes.

Let the Current Bailout Die

Friday, September 26th, 2008

I’m starting out tonight’s post with two stories, to try to help illustrate my position on the bailout. Recently I did some consulting for a financial institution that held the single-A tranches of several trust preferred CDOs that had CMBS, REIT debt, and a lot of junior debt from bank, mortgage, and housing related names. They wanted to know where I would market the bonds at year end 2007. I created a really complex simulation model with regime-switching for credit migration, to simulate how creditworthy the underlying bonds would be.

These bonds were on the cusp; the value of the bonds would vary a lot depending on the assumptions used. The bonds below the single-As in the securitization were all likely to eventually default. All they are worth is the value of interest they will get paid before the securitization shuts them off, plus the warrant value if things improved dramatically. The bonds above the single-As were very likely money good. Losses to the AA and AAA bonds were a remote possibility.

After estimating likely cash flow streams, I tried to estimate where a single-B bond would trade in that environment; that is, if it would trade. I estimated that it would need a 20% annualized return, leading to a dollar price around $35 on a par of $100. The bank pushed back in two ways, suggesting that my discount rate was too high, suggesting that I use 10% (price $65), and they trotted out another analysis from one of the subsidiaries of the rating agencies that was incredibly lightweight, suggesting a price of $85.

Now, did these beasties ever trade? Rarely. But they had traded two months earlier between $25-30, and at year end there was one unusual trade, for which I will give you a fictionalized version of how I think it happened:

Bond Owner: I need a bid for my bonds; you brought this deal to the market. Bid on my bonds.

Investment Banker: There is no market for those bonds; no one knows what they are worth. No one is bidding for them in this environment.

BO: You have a moral obligation to bid on my bonds; you brought the deal to market.

IB: So what, at this point almost no investment bank is willing to honor that.

BO: (begging) Look, I’ll take anything, anything, offer me a cruddy “back bid.” I just need to sell these to realize a tax loss.

IB: (long pause, feeling disgusted, and wanting to tell the guy to go away through a too low bid) Okay then, I’ll offer you $5.

BO: (Happy) Done. Sir, you have those bonds at $5!

IB: Done. (Ugh, what will the risk control desk say?…)

What did I tell my client? I said that I would tell them what my model yielded under their assumptions, but that my recommendation was that they mark them at $35.

Okay, so what’s the right price? $5, $35, $65, $85, $100. The bank marked them down to $75, average of the 10% discount rate and the rating agency’s view, because they could not take the full hit.

Now apply this lesson to the current bailout, and what do we learn?

  • The hold-to-maturity price mentioned by Bernanke is the $75, a value that has no basis in fact.  They don’t want to have the bank take losses.
  • The price that a clever investor would pay if he could buy-and-hold is below $35.  Where?  Not sure, thing have gotten worse since my analysis.
  • The security is worth at least $10, if it pays interest for three years (highly likely).
  • The investment bank that bought the bonds can’t re-sell them.
  • Most bond owners ignore the $5 trade, and ignore the $25-30 trades also.  They mark the bonds much higher, because they can’t take the losses.  They are eating an elephant.  How do you eat an elephant?  One bite at a time.  They can’t take a full loss this year, but will use flexible accounting rules to take those losses over the next three years.
  • A clever bailout would start sucking in these bonds in the teens, quietly.  We’re not doing that, but that is what Buffet would do, and maybe Bill Gross.
  • But these bonds are unique, as are most credit sensitive bonds.  The idea of holding reverse auctions is ridiculous, because I have given you one example, and there are hundreds of thousands, maybe a few million different bond tranches to evaluate.  Only the originally AAA-rated tranches have any size to them.  For any party, even PIMCO, to say that they can come up with the proper pricing for all of them is ludicrous, regardless of whether we go for the panic price, theoretical current “fair price,” or the price at which it is on the bank’s books.
  • This also discourages banks from taking writedowns.  Why write down, when the government will pay you book value?  Or at least, the lowest book value that is common….

Well, that’s one story.  Here’s one more: As a bond manager, I would occasionally come up with unsusal theses that would translate into inquiries after unusual assets.  in late 2002, I began buying floating rate trust preferred securities.  Junior debt — not as safe as senior debt, but because they were floating rate, they did not have the same call provisions as the fixed rate securities.  There could be a lot of profit if the credit market rallied.  So, I started buying slowly, because it is not a thick market, using three brokers to mask my actions.  By the time, I reached 90% of my goal, two things happened.  First, the chief investment officer called to ask what I was doing buying such low yielding securities.  My comment back was that I was earning more than a 5-year senior bank bond, and that it improved the asset-liability match for our insurance client.  He said that he didn’t want much more of them, and I said that I wanted $20 million more.  He agreed, and we were done.  Second, one of the three brokers, the one that I used the least, called me and said that their bank thought there was a buyer in the market, and that prices would rise from here.  I asked what they had left in inventory, and he named a few names that I did not have so much of.  I bought those bonds, and then (after a few weeks) the market repriced dramatically tighter, i.e., higher prices.  We never cleared less than a 10% gain on any of those bonds, which is a “home run” in bond terms.

Here’s my point: the Treasury, should it do the bailout, will find it hard to determine the proper prices for the bonds they want to buy. Why?

  • High prices bail out the banks.
  • Low prices protect taxpayers.
  • No one knows the correct price.
  • Anyone with a large amount of money to invest will artificially inflate the market, unless they are very careful.

The negotiations have broken down, and it is for a good reason.  There is little agreement over what costs the taxpayers should bear for matters that they had little say in creating.  I offer you the following articles that agree with my findings:

With respect to the central question, “Will the Bailout work?” my answer is no.  The assets are too fragmented, and the policy goals too uncertain to make the deal work.

We will see what happens tomorrow.  The Cantor plan may play some role in this, trying to restructure the bill as a reactive bill through an insurance mechanism, while making it sound proactive.  That is prefereable to me, because I think that the next administration whould take time to analyze the best options, rather than let an unaccountable lame duck President and Congress set the tone.  If bailouts are needed because of systemic risk before then, let them be done on a one-off basis.  We don’t need a systemic solution now.

What is the crisis at present?  It is mainly in the short-term lending markets.

That’s not good, because they are big markets, but on the other hand, the percentage losses aren’t large.  Again, I would call Congress to oppose the bailout, in order to let the next President and Congress consider the measure.  Until then, I would do one-off bailouts, like those done for AIG and Fannie, and Freddie.

That may not be optimal policy, and it might be messy, but it might minimize cost to the taxpayers, while causing those that would sell off liabilities to the government to think twice.  Bailouts shoud be painful.

Capitalism <> Greed — Capitalism = Service

Thursday, September 25th, 2008

I had to take a decent amount of time off this evening to get our harp restringed.  Beautiful instrument, but it requires a lot of maintenance.  While talking with the fellow who travels the East Coast restringing and retensioning/regulating harps, I made the comment, “Capitalism isn’t about greed, it is about service.”  He stopped for a moment, and said (something like), “More people need to hear that.”

Well, I’ll say it now, while Capitalism is at low ebb.  Capitalism at its best is run by idealists who have great ideas about how to make the world a better place by offering more and better choices to individuals.  They love their work, and are passionate about what they do.  They are lifelong learners, trying to better themselves and what they offer others.

The value proposition is simple: Capitalism offers more than you previously could have done with your resources.  For those willing to make the effort and run their own businesses, the principle can shine.  Serve others well.  There is no shame in service, as the Protestant Reformation taught, rather, it is the normal life for all people — we must do our duty in all of life, whether because of non-negotiable ties (Family, Church, State), or negotiable ties (Business Agreements).

Capitalism maximizes choice for those that study hard and work hard.  By meeting the needs of others, there is a reward.  The more people you help, and the greater the help offered, the better you can do.

Capitalism derives its moral legitimacy from service.  The idea that greed makes Capitalism legitimate should be discarded.  Greed is evil; it places personal well-being ahead of ethics.  Service places other people in front of our own interests, and promotes harmony.

I’ve been in the financial world for 22 years — I’ve seen real service.  I’ve seen greed.  I’ve seen managements that motivate to excellence, and those that cheat the customer (and employees — the two phenomena are correlated).  I have also succeeded in serving customers, and sadly, failed them (less often, thankfully).

It does not change my conclusion: Capitalism has moral legitimacy because it causes businessmen to deliver high-quality service to customers, not because it is the best way of channeling the energy of greedy men.

Don’t Rush It

Thursday, September 25th, 2008

Policy is at its worst when it is rushed.  Compromises are made under the guise of a crisis that no rational man would take, if given his leisure.  There are other options versus rushing into a bailout:

  • Do “one off” bailouts until the new year.  Then let the new Congress, with fresh authorization from the electorate, attack the problem, rather than a bunch of lame ducks.  (As an aside, the panic engendered by the Bush, Jr. administration over the Iraq war is now serving them badly as they try to rush decisions here.)
  • To the Republicans: no deal is better than a bad deal.
  • To the Democrats: no deal is better than a deal that you will be saddled with if it goes wrong, particularly if you can’t get Congressional Republicans to go along.
  • Another option is doing a new RTC.  Wait for financial institutions to fail, then be the undertaker… selling off the assets in a better credit environment.
  • Yet another option would be offering a tax credit on all mortgage interest paid over 8%.
  • Let the Fed flood the short term money markets with liquidity, sparking inflation that no one can dispute. This will solve the crisis in the short-term lending markets at the cost of more inflation.
  • Relax rules to allow foreigners and private equity (still further) to own US financial assets.
  • Let financial institutions offer shares to the government in exchange for being bailed out.

Anytime someone rushes you to a decision, watch your wallet.  The crisis is not as severe as many would say, and there are other ways of handling the situation.  Stopgap measures will hold us until after the new Congress is in place; there is no reason to rush a bailout.

Post 700, For Real

Wednesday, September 24th, 2008

From the beginning of this blog, I have posted my thoughts about blogging about every one hundred posts.  That was complicated by WordPress, whiich often skipped numbers in posting for its own reasons.  But now, WordPress counts accurately for me, and though my last post was number 950, this one is close to 700.

I have often thanked those who refer to me, through linking or quoting, but I have not often thanked those who actually read me.  By virtue of Quantcast, I have some idea of who reads me, and so I thank:

  • AllianceBernstein L.P. (US)
  • Banque Paribas (US)
  • Citadel Investment Group, L.L….
  • City of New York (US)
  • Credit Suisse Group / CANA (US…
  • DEUTSCHE BANK (US)
  • Dow Jones-Telerate (US)
  • FAHNESTOCK CO. (US)
  • Federal Reserve Information Te…
  • GENERAL ELECTRIC COMPANY (US)
  • GOLDMAN SACHS COMPANY (US)
  • Henry Ford Hospital (US)
  • HSBC Bank plc, UK (GB)
  • Kasowitz Benson Torres Friedma…
  • KOCH INDUSTRIES (US)
  • Lehman Brothers (GB)
  • Metlife (US)
  • Michigan State Government (US)
  • Morgan Stanley Group (US)
  • Morning Star (US)
  • Ottawa General Hospital (CA)
  • PNC Bank (US)
  • Prudential Securities (US)
  • Royal Bank of Canada (CA)
  • State Street Boston Corporatio…
  • THE BOEING COMPANY (US)
  • The Vanguard Group (US)
  • Toronto Dominion Bank (CA)
  • UBS AG (US)
  • Videsh Sanchar Nigam Ltd (IN)
  • Wausau Insurance Companies (US…
  • WELLS FARGO BANK (US)

That is a pretty prestigious group of readers, and so I am grateful for the reception that I have gotten on the web.  I try to do my best for readers, knowing that I can only cover a small subset of all that I am interested in in economics, finance, and business.

Again, my thanks to all who read me.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

 Subscribe in a reader

 Subscribe in a reader (comments)

Subscribe to RSS Feed

Enter your Email


Preview | Powered by FeedBlitz

Seeking Alpha Certified

Top markets blogs award

The Aleph Blog

Top markets blogs

InstantBull.com: Bull, Boards & Blogs

Blog Directory - Blogged

IStockAnalyst

Benzinga.com supporter

All Economists Contributor

Business Finance Blogs
OnToplist is optimized by SEO
Add blog to our blog directory.

Page optimized by WP Minify WordPress Plugin