Day: November 8, 2008

Financial Dominoes

Financial Dominoes

Capital structure is relevant.? Promises are significant.? Contracts are definitive.

This will be short (it better be, I’m tired and want to sleep), but I have no end of friends asking me how bad it is out there.? First I tell them my opinion is a minority opinion.? Second, I tell them that debt-laden economies are inherently inflexible.? Third, I tell them that when the banks are compromised, ordinary monetary policy is useless, because there is no way to make a bank that is worried about its solvency lend more.? Fourth, even extraordinary monetary policy may not work, as the Fed tries to target lending markets, and finds that they can absorb bad assets, but can’t readily recycle them.

The aggregate capital structure of the economy is not a matter of indifference.? If there are many debt claims, and firms with debt finance other firms via debt, who finance other firms via debt, etc., then we set up a bunch of financial dominoes, where a disturbance can knock one down and carry others with it.

This is why the total debt to GDP ratio matters so much.? Economies stop functioning when they have high levels of embedded debt and a slowdown hits.? That is where we are now, at levels of Debt to GDP that exceed those of the Great Depression.? Until we get that ratio down from 350% down to 150%, normalcy will not return.? Air is leaking out of the debt bubble, and the ability to reflate is not there, because the market value of the assets have sagged to such a level that even a zero Fed funds rate will not raise the market value to the levels where the assets are booked.

People are not reliable; they sin; they default.? Economic systems that are primarily equity financed are better able to deal with the nature of man, because they have more flexibility.? Economic systems that are more heavily debt financed face more problems when someone cannot live up to his promises, because it means that others relying on the performance may not be able to live up to their promises also.

Things are different now.? In past economic cycles, there were sectors of the economy that could be stimulated by the Fed lowering the Fed funds rate.? But now, because of too many fixed committments, there is no sector of the American economy that can absorb more debt, and stimulate everyone else.

Thus the task of levering up falls to the Federal government.? But will they be able to honor all the promises that they have made?? Given that they control the printing press, the answer is yes in nominal terms, but no if in inflation-adjusted terms.

Sell Stocks, Buy Corporate Bonds

Sell Stocks, Buy Corporate Bonds

I have lots of models, but I am only one person, so some of my models sit idle becuase I don’t have time to update them.? Well, today, as I was reading Barron’s, I ran across the “Current Yield” column, and read this:

THE STOCK MARKET IS PRICED FOR a recession, but the bond market is priced for a depression. So says Rob Arnott, the brainiac who heads Research Affiliates, an institutional advisory.

That’s not hyperbole. Corporate bonds rated Baa or triple-B, the low end of investment grade by Moody’s and Standard & Poor’s designations, offer the biggest yield premium since the early 1930s, notes RBC Capital Markets.

That’s a problem for pulling the economy out of the credit crisis, but an opportunity for investors. Indeed, investment-grade corporates with near-record premiums arguably offer better return potential than common stocks, especially relative to their risks. “I haven’t seen this many markets offering double-digit opportunities since 1989-90 or ever so briefly in 2002,” says Arnott.

Part of it reflects the sheer weight of numbers. Corporates rated Baa yield about 550 basis points (5.5 percentage points) more than comparable Treasuries, nearly half again the spread in the 2002 post-WorldCom-Enron debacle and twice the average of post-war recessions.

You have to go back to the early 1930s, when Baa corporates yielded 700 basis points over Treasuries, to find a comparable situation. And notwithstanding all the hyperventilation in the media that this is worst financial crisis since the Great Depression, there’s never been such a full-court response to the threat of debt deflation — the $700 billion TARP, the bailout of Fannie Mae and Freddie Mac, the likelihood of trillion-dollar deficits and a doubling in the Federal Reserve’s balance sheet in just over two months.

I know things are bad in the corporate bond market, but I didn’t think it was that bad.? This made me ask, “Hmm… what about my stocks versus bonds model?”? That article is one of my better ones; a lot of time and effort got poured into that.? So, I sat down and re-engineered the model, since, embarrassingly, the original model was lost.

The key question is whether the yield on BBB corporates is more than 3.9% higher than the earnings yield on the S&P 500.? The answer is yes, and that means we should sell stocks and buy corporate bonds.? But, here is the embarrassing thing for me.? The first recent signal to sell stocks and buy bonds came in mid-August, but since I didn’t track the model regularly, I missed that.? Since the original model worked off monthly data, even selling in early September would have preserved a lot of value.? It is not as if corporate bonds have done well since August, but they have done much better than the S&P 500.

Here’s a graph summarizing 2008 via my model:

When the green line goes over 3.9%, it is time to buy corporate bonds. That is not a frequent occurrence; this model gives of signals only a few times per decade. Check out my original piece for more details.

So, with that, I offer my conclusions:

  • It is still time to allocate money to corporate bonds versus equities.? Where I have flexibility with my own money, I am allocating money away from Equity and to BBB investment grade and high yield corporates.
  • Though there are a lot of reasons to worry, corporate yield spreads discount a lot of trouble.
  • The model indicates a fair value of the S&P 500 at around 700.? Uh, I’m not predicting that, but if we hang around at yield levels like this for long, yes, the equity market will adjust to the competition.? More likely is the equity market treads water while corporates rally.
  • A caveat I toss out is that all areas of the credit markets where the government is not meddling are disproportionately hurt, because investors are fleeing toward guaranteed areas.? Thus, corporates are hurting.
  • College endowments and other investors that hate to buy conventional assets should consider corporates now.? It is my bet that a portfolio of low investment grade and junk grade corporates will outperform a 60/40 portfolio of Stocks and T-Notes.
  • If you have the freedom to sell protection on a broad basket of corporates, this might be a good time to do it, when everyone else is scared to death.? Time to insure corporate credit, perhaps.
  • One more caveat before I am done.? The rule has only been tested on data since 1953.? It is not depression-proof.??? I hope to gather the data from that era and validate the formula, but that will be difficult.

So, be careful out there, and remember that corporate bonds typically do better than stocks in a prolonged bear market for credit.? Yield levels like the present typically bode well for corporate bonds versus stocks.

Bring Out Yer Dead! (thud)

Bring Out Yer Dead! (thud)

I’ve been beating the avoid the US automakers drum for six years now.? When I was a corporate bond manager, one of the first things that I did was sell 90% of my Ford and GM bonds that I inherited from the prior manager.? When I began writing for RealMoney, I wrote pieces like this:

David Merkel
Open Letter to General Motors’ CFO
By David Merkel
RealMoney.com Contributor

12/9/2004 11:11 AM EST
URL: http://www.thestreet.com/p/rmoney/davidmerkel/10198313.html

General Motors (GM:NYSE) BEARISH
Price:?$38.14??|??52-Week Range:?$36.90-$55.55

  • GM should refinance at least half its 2005 and 2006 maturities while rates remain low.
  • The company’s future is threatened by any increase in bond yields.
  • Position: None

    Sir: Though I am not as bearish as my friend Peter Eavis on the prospects for your company, I do want to give you some friendly, if unsolicited, advice: Refinance at least half of your 2005 and 2006 maturities while rates remain low.

    With over $50 billion of principal coming due in the next two years, the future of GM (GM:NYSE) is threatened by any increase in bond yields. With the likely weakness in the dollar, yields on Treasury obligations are unlikely to remain this low, in my opinion. Further, though spreads for GM and GMAC are not at historically tight levels, spreads in the corporate bond market are at levels not seen since 1997. Take advantage of the demand (both domestic and international) for yieldy paper while you can. For that matter, do another convert deal. It may put a ceiling over your stock price (but, hey, isn’t there one there now?), but the convertible arbs will give you cheap financing while you figure out how to make your auto operations profitable (and design cars that people crave).

    Though your ratings are stable from Moody’s and Standard & Poor’s at present, who can tell how long that will last? GM and GMAC debt are only one notch above junk at S&P, and I can tell you that you will have a hard time selling debt if you ever do get downgraded by S&P. Even if Moody’s leaves you an investment-grade rating, I will tell you that there is not enough buying capacity in the bond market for crossover credits of your size. Your yields would have to rise to the point where equity investors find your bonds an interesting speculation, as was true of auto bonds in mid-2002.

    Further, do you want to be subject to the vicissitudes of your cousin Ford (F:NYSE) ? If they catch cold, you may too, at least in the eyes of the ratings agencies. But I digress.

    It is always better to seek financing when it is offered, rather than when you need it. Your spreads are not going to get materially tighter, in my opinion, absent a partial refinancing that gives the bond market more confidence in how you will meet your short-term obligations.

    I wish you nothing but the best, if for no other reason than as a U.S. taxpayer, I don’t want to bail GM or Ford out.

    Sincerely,

    David J. Merkel

    P.S. To the CFO of Ford: This goes for you as well. The numbers differ, your spreads are currently tighter than those of GM, but you lack one thing that GM has. GM could sell the non-auto financing assets of GMAC in a pinch, which is presently a very valuable franchise that you don’t possess. Refinance while the bond market is friendly.

    I also wrote pieces like this:


    David Merkel
    GM on “Death Ground”
    11/17/2005 5:15 PM EST

    The last time I used the phrase “death ground” it was with respect to Fannie Mae. It engendered some confusion then so let me explain the term. “Death Ground” is a term from Sun Tzu’s The Art of War. It is when a General faces a situation where an army unit is in nearly hopeless shape, and the General manuevers the unit into a place where flight is impossible, so that the unit will fight to the death, because they have nothing to lose. Soldiers that motivated sometimes win; it is a last-ditch strategy.

    That describes GM today. The CEO announced that in a letter posted on the Financial Times website, “I’d like to just set the record straight here and now: there is absolutely no plan, strategy or intention for GM to file for bankruptcy” GM faces a host of issues, revolving around legacy liabilities, poor design, poor marketing (reliance on sales, rather than everyday low pricing), high production costs, low flexibility, and high debt. Almost everything has to go right for GM to survive against much stronger competition; to me, that’s death ground.

    That’s not an exhaustive list. Add into that the possible sale of GMAC, which is the crown jewel of GM, and you can sense the desperation. This is not a company to be playing around with on the long side; truth is, the world doesn’t need GM when it has Toyota. Maybe the US government will bail out GM the way they did Chrysler, but I really wouldn’t expect that.

    Long GM debt was trading in the mid-60s this morning for a 12%-ish yield. It improved after the CEO’s statements this afternoon; the longs got a gift. I would take the opportunity to lighten up on long positions in GM stock, and any bonds dated past 2010. Take the $10-15 buck haircut off par, lest you have to settle for a recovery in the $30s five years out. (The 2036 7.75% zero-to-fulls are trading in the low $20s. Assuming an interest rate of about 7-9%, and a default 5 years out, that discounts a recovery in the mid-$30s.)

    Position: short FNM, long TM

    And this:

    GM: Less Has Changed Than Meets the Eye, by David Merkel

    6/30/2006 8:24 AM EDT

    The story of GM over the past few decades has been to sell off desirable assets to fund the core auto operations, close factories and reduce jobs in North America. Its recent round of adjustments is only different because of the desperateness of the situation. Even with the labor concessions being discussed, GM’s cost structure will remain higher than most of its competition.

    Consider the ratings agencies that are “inside the wall” and possess more information than other market participants. Even after the changes made, GM’s debt is rated Caa1 (negative outlook) by Moody’s and B (negative watch) by S&P. The ratings on GM’s debt reflect a highly speculative company with an uncertain future. The debt of GM, though the price is up from its lows still reflects significant uncertainty of full payment. Long debt trades in the mid-$70s.

    We still don’t know whether the Pension Benefit Guaranty Corporation will go for the sale of 51% of GMAC. GM has only made a dent in the total liabilities that it faces in pension and health care (active and retiree). Does the PBGC want to lose a claim on one of the more valuable aspects of the firm should it go under?

    Finally, sales have been disappointing, and discounting must be resorted to in order to “move the metal.” GM’s offerings have improved of late, but that might only be enough to get someone to buy a GM instead of a Ford. The improvements at GM don’t place the company on the same footing as Toyota or Honda from either a cost or marketability basis.

    GM may be able to eke out a small GAAP operating profit in the short run from the changes made. It is still in a lousy competitive position against firms with stronger balance sheets and lower cost structures. My estimate of the long-run outcome has not changed. Avoid the stock and unsecured debt of GM.

    P.S. At least GM is showing a little vigor relative to Ford (F:NYSE) , but that’s not saying much. Ford’s situation, if judged by the asset markets (stock, bond and credit-default swaps), has worsened relative to GM. Credit-default swaps now show Ford as more likely to default over the next five years than GM. What a mess.

    At the time of publication, Merkel and/or his fund was short GM and Ford, though positions may change at any time.

    FInally there is this piece four months ago, where I said: As I have said many times before GM common is an eventual zero.? Same for Ford.? All the errors in labor relations over the years, compounded with interest, are coming back to bite, hard.

    Why throw good money after bad?? Why reward exceedingly lousy managers, and unions that have sucked the carcasses of the auto companies dry? Throw in $25 billion.? It won’t be enough.? Toyota and Honda are so much better managed, that they will win anyway.

    In 2002, we let 20+ steel companies die.? The valuable assets were bought up, union contracts were torn up, and the industry regained sanity.? The industry is in much better shape today, and able to compete against the rest of the world.

    We should do the same with the autos.? Let GM, Ford and Chrysler die.? Let Toyota, Honda, Daimler, Renault, Hyundai, Magna, Kirk Kerkorian (dreamer), etc., bid for the assets in bankruptcy.? Many jobs will be retained, though at fairer levels of compensation.? Remember my piece Rethinking Comparable Worth?? We are facing international comparable worth issues in labor in the auto sector now.

    Before there were the possibilities with government bailouts, GM and Ford said they had more than enough cash.? But when the carrot of cheap financing is in front of them, they tell their tales of woe.? Examples from the media:

    I could add to the examples in other sectors — MBIA and Ambac seem to be? headed to zero as well.? Another set of examples of too much debt and too little transparency.

    But to close on the automakers, I highlight the well-written article at the Curious Capitalist.? The companies are not as critical as their assets, which will be bought by others, and many of the jobs will be retained.? Any bailout will throw good money after bad, and will not preserve the auto industry here in the long run.

    Full disclosure: long HMC MGA

    What Do You Have To Hide?

    What Do You Have To Hide?

    Bloomberg sues the Fed for refusing to disclose what sort of collateral they are lending against.? I come at this from having worked in insurance for two decades.? Insurers have to disclose every asset that they own in their Statutory filings.? When I looked at a bank’s call report recently, I was surprised to see only summary data available.? The insurance industry has high disclosure, and it hasn’t hurt them.? Why should the Fed cower, and refuse to reveal what they are lending against?? Five possibilities, and none of them good:

    • The Fed is breaking its own rules, and lending on collateral that it publicly said that it wouldn’t lend against.
    • They are playing favorites with institutions, and don’t want that to be revealed.
    • The assets in question are technically in compliance with the rules of the Fed, but are worth far less than the amount loaned against them.
    • Certain banks would be embarrassed by revealing what they own.
    • It’s just a power game, and the Fed thinks it is above the law, particularly during a crisis (that it helped to cause).

    For another example, I would be happy to see who they are lending to in their CPFF program.? Are they lending a lot to AIG through CP?? Anyone else notice that AIG is A-/A3 from S&P and Moody’s which would make them A-2/P-2, and ineligible for the Fed to lend to, but S&P and Moody’s still have them at A-1/P-1.? Weird.

    In my opinion, there is no good reason why the Fed can’t disclose the collateral, and the institutions involved.? They assure us that they are being upright and prudent; let them prove it.

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