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Archive for March, 2009

Of Course not at Par; That’s Par for the Course

Tuesday, March 31st, 2009

There are several truths well-known to educated investors that have been glossed over in all of the discussions of mark-to-market accounting, or SFAS 157.  (Really SFAS 133, but SFAS 157 clarified it.)

  • Accounting rules have little impact on stock prices.  Almost every academic study on accounting rules supports that idea.  Why?  Investors attempt to estimate the stream of free cash flows that an asset will throw off.  Accounting rules can help or hinder that.  Because SFAS 157 attempts to calculate a present value of cash flows for level 2 and 3 assets, it aids in that estimation.
  • Parties involved confuse regulatory with financial accounting.  Mainly due to the laziness of financial corporations in the boom phase of our markets, they looked to minimize effort, and make the accounting the same for regulatory and financial purposes.  This was foolish, because there is no one accounting method that is ultimate.  Every financial statement answers one main question.  For GAAP, the balance sheet asks “What is the net worth?”  Regulatory accounting would ask “Is net worth positive under conditions of moderate stress, including the possibility that markets go illiquid, and we have to rely on cash flows to pay off the liabilities?”
  • There are always two ways to do accounting.  You can do mark-to-market, or you can do book value accounting with impairment.  Darkness encourages skepticism.  In a period where there are few credit risks, book value  accounting will be well-received.  In an era where credit risks are significant, book value accounting will be no help, investors will distrust book value, and the effect might be less than where fair value estimates are provided.   Regardless, the cash flows will still flow.
  • Equity-like investments deserve equity-like accounting.  They should be market to market, as equities are.  With derivatives, this is the reason that we mark them to market, their values are so variable.  So we should mark speculative mortgage investments: estimate the future cash flows, and discount them at a high, but not equity-like interest rate.
  • But what of assets that are seemingly money good, but the few trades that have happened indicate a value at 60% of par, possibly because of The Bane of Broken Balance Sheets, or Time Horizon Compression.  Here’s the problem: we have a lot of people alleging that those values can’t be right.  Let them stand up and start buying to prove it all wrong.  Part with precious liquidity to gain uncertain yield.  It is quite possible that we are in a depression, and as such, there are too many assets relative to the ability to fund them — asset values must fall.  Don’t immediately assume that the few trades in the market are ridiculous because they are lower than your current marks.
  • Some argue that there is an inconsistency between loans and bonds.  Bonds get marked to market, while loans are marked at book.  There is no inconsistency.  The loans are held to maturity, unless sold.  The bonds could be held to maturity as well, in which case they are at book value, and only changed if there is a need for a writedown, the same as the loans.  Most companies have not chosen that option, largely because they want the right to sell assets if they want to.  But that locks in their accounting; if they want the ability to sell, they must accept balance sheet volatility.
  • We have to differentiate SFAS 157 from misapplications of SFAS 157, which might be driven by the auditors.  SFAS 157 does not mean last trade.  In thin markets, companies are free to use discounted cash flow and other analyses to estimate fair value.
  • Now all of this said, practically, SFAS 157 leads to overestimating the value of assets.  In the consulting work I have done, companies are not willing to mark their volatile assets down to levels near their fair value, much less last trade, which is worse.  They are hoping for some huge return of risk-taking to appear, and revalue their assets. What if present conditions persist for five to ten years, where there are too many debts relative to the wilingness to fund them, as in the Great Depression?  In that situation, SFAS 157 would prove to be too flexible, with banks marking assets higher than warranted.

The anti-SFAS 157 arguments rely on an assumption that things aren’t so bad — that mean-reversion is right around the corner.  We are in a situation where marginal cash flows to purchase dud assets aren’t there.  Mean reversion is a long way off, and the valuations of financial assets reflect that consistently.  Try selling a bunch of whole loans held at par.  See what the offers are.  Why aren’t banks doing that to raise liquidity?  Because the prices don’t justify it.

You can’t fight cash flows.  Accounting exists to partition cash flows into periods, so that analysis of businesses can be done, and debt financing can be secured.  In the end, cash flows win out, regardless of the accounting methods.

Thus my opinion: SFAS 157 is a good standard, and I am no fan of the FASB generally.  There are misapplications of SFAS 157, forced by auditors, I believe.  SFAS 157 already offers decent flexibility to management teams — let them use that flexibility, but no more.  After that, let the regulators set their own solvency rules.

-==-=-=–==–=-=-=-==–=-==-=-=-

PS — What foes of SFAS 157 are unwilling to admit, is that lenders lent money near the peak of an amazing bull market, and now the collateral values lent against are far less than imagined at the time of lending.

It’s like the FRAM oil filter ad — “you can pay me now or pay me later.”  There is a great deal of hubris involved in arguing that the market as a whole is out-of-whack.  (Much as I had hubris toward the end of the bull phase… let me stab myself.)  In ordinary bear markets, there is some strength somewhere to support asset values.  That is not true now.  We are dealing with something not normal over the last 70 years, and overall market values are reflecting that.  Eventually accounting values will get there, as they did in the thirties.

A Day in the Life of John Davidson, Part VII

Friday, March 27th, 2009

Cast of Characters, in order of appearance

  • John Davidson — Protagonist, CEO of Wonderful Life
  • Peter Farell — Chief Investment Officer for Mega Insurance, the holding company for all of the operating subsidiaries.
  • Brent Fowler — CEO of Whata Life
  • Henry Goldsmith — CEO of Mega’s P&C reinsurance subsidiary
  • Marc Blitztein — CEO of Mega’s domestic P&C insurance
  • Brad Baldwin — CEO of Mega Insurance
  • Stan Bullard — Scion of the family that owns Mega
  • Caleb Matmo — Runs a firm that analyzes insurance financial statements, consulting for Mega

=–=-==–=-=-=-=-=-=-=-=-=-=

John was the first to make it to the Men’s room.  Finding the most distant stall, he bolted the door, and said to himself, “This is what you get for having too much tea.”  Not long after that thought, he heard the bathroom door open, hearing the voices of Brent Fowler and Henry Goldsmith.

HG: I don’t know how you do it, Brent.  Isn’t life insurance supposed to be a slow growing business?

BF: If you motivate your sales force effectively, life insurance can be a growth business.  There are always ways to sell policies and add assets effectively if you just spot the opportunities and seize them. v I have a motivated sales cuture that thrives on the challenge of doing more — beating our prior best performance!

HG: I get it, Brent.  But what if underwriting suffers?  In my end of the insurance business, fast growth and bad underwriting go hand-in-hand.

BF: We watch our underwriting carefully.  Our agents are our first line of defense in underwriting.

HG: But how do they balance the objectives of growth and safety? — that seems tough, particularly with long-dated contracts.  Mine are short, so I don’t have to worry so much.

BF: That balance is one of my secrets, and why I have done so well….

The voices trailed as they left, to be replaced by the voices of Marc Blitztein and Peter Farrell.

PF: Your simple investment needs are a plus for you in this environment.

MB: Thanks, but what of the rest?  How is John doing?

PF: John?  God bless him, he’s the responsible one.  He pulled in his horns, hurting immediate profitability before the crisis began.  Brent, on the other hand, continued to be a yield hog.  I can’t tell you how big his current unrealized capital loss is, but he is stubbornly focused on current income, because his bonus is largely based on that.  John’s bonus is the same, but he cared more about the long-term safety of the company.

MB: That’s John alright… they don’t make many like him, and I hope he survives this.

PF: Me too… I really like his style.

Their voices drifted off.  John wondered if he should leave, when he heard three more voices — Stan Bullard, Caleb Matmo, and Brad Baldwin.  John thought, “Grand Central Station…”

BB: I appreciate your work, Mr. Matmo.

SB: And I as well.  For a relative neophyte like me, you have made our decisionmaking process clearer.

CM: Thank you both.  I have simply tried to think like a businessman, and analyze the need for free cash flow, which is often obscured in insurance organizations.

BB: You have made it clear to me.

SB: And me as well, though it is a pity that we will have to eliminate one of our life companies and merge it into the survivor.

CM: We must focus on the risk-adjusted growth of free cash flow.  That is the lifeblood of our business, and with out that companies die.

As they exited the Men’s room, John left the stall, thinking, “I do not know what is going on, but if I am going out, I am going out with the flags flying.  I have done my best for this firm; I have nothing to be ashamed of.”  He washed his hands, and returned to the conference room.

The Great Omission

Friday, March 27th, 2009

This seems to be the era for dusting off old articles of mine.  This one is one year old, I wrote it on April Fools’ Day — Federal Office for Oversight of Leverage [FOOL].  (Today I would simplify it to: Federal Office Overseeing Leverage.) I would recommend a re-read of that article, and encourage those at the Treasury to realize the enormity of what it is trying to do.

Well, now the Treasury ain’t foolin’ around.  They think they can harness systemic risk.  Check out the speech of Mr. Geithner, and his proposed policy outline.  What are the main points of the policy outline?

1) A Single Independent Regulator With Responsibility Over Systemically Important Firms and Critical Payment and Settlement Systems

  • Defining a Systemically Important Firm
  • Focusing On What Companies Do, Not the Form They Take
  • Clarifying Regulatory Authority Over Payment and Settlement Activities

2) Higher Standards on Capital and Risk Management for Systemically Important Firms

  • Setting More Robust Capital Requirements
  • Imposing Stricter Liquidity, Counterparty and Credit Risk Management Requirements
  • Creating Prompt-Corrective Action Regime

3) Registration of All Hedge Fund Advisers With Assets Under Management Above a Moderate Threshold

  • Requiring Registration of All Hedge Funds
  • Mandating Investor and Counterparty Disclosure
  • Providing Information Necessary to Assess Threats to Financial Stability
  • Sharing Reports With Systemic Risk Regulator

4) A Comprehensive Framework of Oversight, Protections and Disclosure for the OTC Derivatives Market

  • Regulating Credit Default Swaps and Over-the-Counter Derivatives for the First Time
  • Instituting a Strong Regulatory and Supervisory Regime
  • Clearing All Contracts Through Designated Central Counterparties
  • Requiring Non-Standardized Derivatives to Be Subject to Robust Standards
  • Making Aggregate Data on Trading Volumes and Positions Available
  • Applying Robust Eligibility Requirements to All Market Participants

5) New Requirements for Money Market Funds to Reduce the Risk of Rapid Withdrawals

6) A Stronger Resolution Authority to Protect Against the Failure of Complex Institutions

  • Covering Financial Institutions That May Pose Systemic Risks
  • i. A Triggering Determination

    ii. Choice Between Financial Assistance or Conservatorship/Receivership

    • Options for Financial Assistance
    • Options for Conservatorship/Receivership

    iii. Taking Advantage of FDIC/FHFA Models:

  • Requiring Covered Institutions to Fund the Resolution Authority

(As an aside, did anyone else notice that point 6 didn’t make it into the introductory outline?)

The Great Omission

There’s a bias among Americans for action.  That is one of our greatest strengths, and one of our greatest weaknesses, and I share in that weakness.  Whenever a crisis strikes, or an egregious crime is committed, or a manifestly unfair scandal develops, the klaxon sounds, and “Something must be done!  This must never, never, NEVER happen again!”

So, instead of merely having a broad-based law against theft/fraud, and allowing the judges discretion for aggravating/extenuating circumstances, we create lots of little theft/fraud laws to fit each situation, fighting the last war.  Oddly, because of specificity of many statutory laws, it weakens the effect of the more general theft/fraud laws.

The Treasury will fight the last war, as they always do, but there is a great omission in their fight, even to fight the last war.

Why did they ignore the Fed?  Why did they ignore that many of the existing laws and regulations were simply not enforced?  For much but not all of this crisis, it was not a failure of laws but a failure of men to do their jobs faithfully.

Consider this opinion piece from the Wall Street Journal today.  There is some disagreement, which helps to flesh out opinions.  I think a majority of them concur with the idea that the greatest creator of systemic risk, particularly since 2001, was easy credit from the Federal Reserve.  It’s been my opinion for a long time.  For example, consider this old (somewhat prescient) CC post from RealMoney:


David Merkel
The Fed Vs. GSEs: Which Is Most Threatening to the Economy?
2/24/04 1:35 PM ET
I found Dr. Greenspan’s comments about Fannie and Freddie this morning a little funny. I agree with him that the government-sponsored entities, or GSEs, have to be reined in; they are creating too much implied leverage on the Treasury’s balance sheet. They may prove to be a threat to capital market stability if they get into trouble; they are huge.

Well, look to your own house, Dr. Greenspan. As it stands presently, the incremental liquidity that the Fed is producing is going into housing and financial assets. The increase in liquidity has led to low yields, high P/E ratios and subsidized issuance of debt. All of this has led to stimulus for the economy and the equity and bond markets, but at what eventual cost? The Fed has far more systemic risk to the economy than the GSEs.

No stocks mentioned

Since then, the GSEs have failed, and the Federal Reserve is trying to clean up the mess they created in creating the conditions that allowed for too much leverage to build up.  Now they are fighting deleveraging by bringing certain preferred types of private leverage onto the balance sheet of the Fed/Treasury/FDIC.

The first commenter in the WSJ piece makes some comments about monetary aggregates, suggesting that the Fed had nothing to do with the housing bubble.  Consider this graph, then:

Outpacing M2 (yellow) for two decades, MZM (green), the monetary base (orange) and my M3 proxy, the total liabilities of banks in the Federal Reserve really began to take off in the mid-90s, and accelerated further as monetary policy eased starting in 2001.

This brings up the other part of the omission: bank and S&L exams were once tougher, but became perfunctory.  The standards did not shift, enforcement of the standards did.  Together with increased use of securitization, and to some extent derivatives, this allowed the banks to lever up a lot more, creating the systemic risk that we face today.

There are other problems (and praises) that I have with (for) the Treasury’s proposals, and I will list them in the addendum below.  But the most serious thing is what was not said.  The government can create as many rules and regulations as it likes, but rules and regulations are only as good as how they are executed.  The Government and the Fed did not use its existing powers well.  Why should we expect things to be better this time?

Addendum

Praises

  • A single regulator for large complex firms is probably a good idea.  Perhaps it would be better to limit the total assets of any single financial firm, such that any firm requiring more than a certain level risk based capital would be required to break up.
  • Higher risk-based capital is a good idea, but be careful phasing it in, lest more problems be caused.
  • With derivatives, most of the proposal is good, but the devil is in the details of dealing with nonstandard contracts.

Problems

  • Risk based capital should higher for securitized assets versus unsecuritized assets in a given ratings class, because of potentially higher loss severities.
  • You can’t tame the boom/bust cycle.  You can’t eliminate or tame systemic risk.  It is foolish to even try it, because it makes people complacent, leading to bigger bubbles and busts.
  • Hedge funds are a sideshow to all of this.  Regulating them is just wasted effort.
  • With Money Market funds, my proposal is much simpler and more effective.
  • Do you really know what it would take to create a macro-FDIC, big enough to deal with a systemic risk crisis like this?  (The FDIC, much as it is pointed out be an example, is woefully small compared to the losses it faces, and it is not even taking on the large banks.)  It would cost a ton to implement, and I think that large financial services firms would dig in their heels to fight that.  Also, there would be moral hazard implications — insured behavior is almost always more risky than uninsured behavior.
  • Very vague proposal with a lot of high-sounding themes.  (late addition after the initial publishing, but that was my first thought when I read it.)

Sell Stocks, Buy Corporate Bonds (II)

Friday, March 27th, 2009

After a sharp bear market rally, people are feeling better about stocks.  But corporate bonds have not bought into the stock market rally.  Aside from noises from the US government, whose actions may or may not pan out, there is little reason for optimism in the real economy, as GDP continues to shrink.

At a time like this, I reissue my call to sell stocks and buy corporate bonds, even junk bonds.  When the advantage of corporate bond yields are so large over the earnings yields of common stocks, there is no contest.  When the yield advantage is more than 4%, bonds win.  It is more like 6% now, so enjoy the relatively stable returns from corporate bonds.

Holding and Operating Companies

Wednesday, March 25th, 2009

Around 25 years ago (I feel old), I was a teaching assistant at UC-Davis.  I was nominated for the best teaching assistant twice, but never won the prize.  That was fine with me.  I did my best, whether rewarded or not.

My love of teaching is what drives me to write this blog.  I like to think that I am a good teacher, much as I know that I am not perfect at it.

A reader asked me to explain the difference between holding and operating companies.  I will do that here, realizing that I am summarizing a complex subject.

The nature of a holding company is to be a financing vehicle.  The holding company owns (holds) other operating companies, and receives dividends from them.  The holding company pays interest on its debts, and dividends to shareholders, if any.  A holding  company is a means of controlling a number of operating companies with somewhat disparate goals.  Certain common functions are centralized, like accounting, finance, human resources, etc.

Now the operating companies are typically at the lower level of the holding company structure, and there may be holding companies  held by holding companies, before getting to the operating companies below.

Typically the owners of stocks and bonds own securities from holding companies.  There are operating company bonds, and sometimes stocks trade where the holding company does not own 100%.  Those are unusual.

Holding companies exist to organize operating businesses into a coherent whole.  It may not always succeed, but that is the goal.

Translation: We Really, REALLY, Hate You Guys!!

Tuesday, March 24th, 2009

From an earlier post, point 4:

We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.” [emphasis mine]

So said Mr. Luo, a director-general at the China Banking Regulatory Commission.  I’ve been saying for a long time that China is stuck, and that we are their problem, and not vice-versa.  There may come a point where they stop buying US Dollar-denominated debt, and let existing debt mature, but that will come after a shift in their own economy where they are no longer driven bythe promotion of their exports.  There aren’t many large good alternatives to US debt for parking the proceeds from exporting aggressively.

So today, we get another volley from China as they realize that they are stuck holding US Dollar denominated assets that they are more certain than ever will depreciate.  They see injustice in having bought too many dollars in exchange for the exports they paid to promote to the US.  Excerpting from the article:

People’s Bank of China Governor Zhou Xiaochuan said he wants to replace the dollar, installed as the reserve currencyWorld War II, with a different standard run by the International Monetary Fund (IMF). after

China, the top holder of US Treasury bonds with 739.6 billion dollars as of January, according to American figures, earlier expressed concern over its investment as the world’s largest economy battles a deep recession.

“The outbreak of the crisis and its spillover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system,” Zhou wrote in an essay posted on the bank’s website Monday.

Zhou’s comments come ahead of the G20 summit from April 2 in London, where world leaders and international organisations including the IMF are to discuss reforming the financial system.

He suggested the IMF’s Special Drawing Rights, or SDR, could serve as a super-sovereign reserve currency as it would not be easily influenced by the policies of individual countries.

Russia has also proposed the summit discuss creating a supranational reserve currency. The IMF created the SDR as an international reserve asset in 1969, but it is only used by governments and international institutions.

“The reform should be guided by a grand vision and start with specific deliverables,” Zhou wrote. “It should be a gradual process that yields win-win results for all.”

However, China’s proposal was unlikely to lead anywhere because the SDR is not a currency system backed up by a government, independent Shanghai-based economist Andy Xie said.

Xie said the proposal was probably a protest aimed at Washington’s plan to buy one trillion dollars of its own debt, diluting the value of China’s dollar reserves and raising fears of inflation.

“It’s a sad situation: China is America’s banker. America owes so much to China, but it’s not afraid of China,” he said. “China is America’s hostage. It’s not the other way around.” [emphasis mine]

As the world’s main reserve currency, US dollars account for most governments’ foreign exchange reserves and are used to set international market prices for oil, gold and other currencies.

As the issuer of the reserve currency, the US pays less for products and borrows more easily.

Strategic Drawing Rights are a cute idea, but it would be too small  to support global trade.  Like the Euro, it is a political construct, but one with less dedicated political and economic support.

As I commented in my piece, It is Good to be the World’s Reserve Currency, there’s no good alternative to the US Dollar yet. Like the mercantilists of old, who bought gold dear, and sold it cheaply, so will it be for China — they bought US Dollar claims dear, but will sell them more cheaply.   This is the price of forced industrialization.

There will come a time when the US Dollar is no longer the world’s reserve currency, but there needs to be a worthy competitor, or a willingness to do without a single clearing unit.  This is an age of computers, so there does not need to be a single dominant unit of exchange, but habits die hard.  It will probably take some disaster to dislodge the US Dollar, and force the changeover.  Whether that comes through inflation, default, partial default, or war remains to be seen.

Liquidity and the Current Proposal by the US Treasury

Tuesday, March 24th, 2009

One of the earliest pieces at this blog was What is Liquidity?, followed by What is Liquidity? (Part II).  I’ve written a bunch of pieces on liquidity (after doing a Google search and being surprised at the result), largely because people, even sophisticated investors and unsophisticated politicians and regulators misunderstand it.  Let’s start with one very simple premise:

Many markets are not supposed to be liquid.

Why?

  • Small markets are illiquid because they are small.  Big sophisticated players can’t play there without overwhelming the market, making volatility high.
  • Securitization takes illiquid small loans and transforms them into a bigger security(if it were left as a passthrough), which then gets tranched into smaller illiquid securities which are more difficult to analyze.  Any analysis begins with analyzing the underlying loan collateral, and then the risks of cashflow timing and default.  There is an investment of time and effort that must go into each analysis of each unique security, and is it worth it when the available amount to invest in is small?
  • Buy-and-hold investors dominate some markets, so the amount available for sale is a small portion of the total outstanding.
  • Some assets are opaque, where the entity is private, and does not publish regular financial statements.  An  example would be lending to a subsidiary of a corporation without a guarantee from the parent company.  They would never let and important subsidiary go under, right?  ;)
  • The value of other assets can be contingent on lawsuits or other exogenous events such as natural disasters and credit defaults.  As the degree of uncertainty about the present value of free cash flows rises, the liquidity of the security falls.

When is a securitization most liquid?  On day one.  Big firms do their due diligence, and put in orders for the various tranches, and then they receive their security allocations.  For most of the small tranches, that’s the last time they trade.  They are buy-and-hold securities by design, meant to be held by institutions that have the balance sheet capacity to buy-and-hold.

When are most securitizations issued?  During the boom phase of the market.  During that time, liquidity is ample, and many financial firms believe that the ability to buy-and-hold is large.  Thus thin slices of a securitization get gobbled down during boom times.

As an aside, I remember talking to a lady at a CMBS conference in 2000 who was the CMBS manager for Principal Financial.  She commented that they always bought as much of the AA, single-A and BBB tranches that they could when they liked the deals, because the yield over the AAA tranches was “free yield.”  Losses would never be that great.  Privately, I asked her how the securitizations would fare if we had another era like 1989-92 in the commercial property markets.  She said that the market was too rational to have that happen again.  I kept buying AAA securities; I could not see the reason for giving up liquidity and safety for 10, 20, or 40 basis points, respectively.

Typically, only the big AAA tranches have any liquidity.  Small slices of securitizations (whether credit-sensitive or not) trade by appointment even in the boom times.  In the bust times, they are not only not liquid, they are permafrost.  In boom times, who wants to waste analytical time on an old deal when there are a lot of new deals coming to market with a lot more information and transparency?

So, how do managers keep track of these securities as they age?  Typically, they don’t track them individually.  There are pricing grids or formulas constructed by the investment banks, and other third-party pricing services.  During the boom phase, tight spread relationships show good prices, and an illusion of liquidity.  Liquidity follows quality in the long run, but in the short run, the willingness of investors to take additional credit risk supports the prices calculated by the formulas.  The formulas price the market as a whole.

But what of the bust phase, where time horizons are trimmed, balance sheets are mismatched, and there is considerable uncertainty over the timing and likelihood of cash flows?  All of a sudden those pricing grids and formulas seem wrong.  They have to be based on transactional data.  There are few new deals, and few trades in the secondary market.  Those trades dominate pricing, and are they too high, too low, or just right?  Most people think the trades are too low, because they are driven by parties needing liquidity or tax losses.

Then the assets get marked too low?  Well, not necessarily.  SFAS 157 is more flexible than most give it credit for, if the auditors don’t become “last trade” Nazis, or if managements don’t give into them.  More often than not, financial firms with a bunch of illiquid level 3 assets act as if they eating elephants.  How do you eat an elephant?  One bite at a time.  They write it down to 80, because that’s what they can afford to do.  The model provides the backing and filling.  Next year they plan on writing it down to 60, and hopefully it doesn’t become an obvious default before then.  Of course, this is all subject to limits on income, and needed writedowns on other assets.  I have seen this firsthand with a number of banks.

So, relative to where the banks or other financials have them marked, the market clearing price may be significantly below where they are currently marked, even though that market clearing price might be above what the pricing formulas suggest.

The US Treasury Proposal

The basics of the recent US Treasury proposal is this:

  • Banks and other financial institutions gather up loans and bonds that they want to sell.
  • Qualified bidders receive information on and bid for these assets.
  • High bid wins, subject to the price being high enough for the seller.
  • The government lends anywhere from 50-84% of the purchase price, depending on the quality and class of assets purchased.  (I am assuming that 1:1 leverage is the minimum.  6:1 leverage is definitely the maximum.)  The assets collateralize the debt.
  • The FDIC backs the debt issued to acquire the assets, there is a maximum 10 year term, extendable at the option of the Treasury.
  • The US Treasury and the winning private investor put in equal amounts, 7-25% each, to complete the funding through equity.
  • The assets are managed by the buyers, who can sell as they wish.
  • If the deal goes well, the winning private investors receive cash flows in excess of their financing costs, and/or sell the asset for a higher price.  The government wins along with the private investor, and maybe a bit more, if the warrants (ill-defined at present) kick in.
  • If the deal goes badly, the winning private investors receive cash flows in lower than their financing costs, and/or sell the asset for a lower price.  The government may lose more than the private investor if the assets are not adequate to pay off the debt.

I suspect that once we get a TLGP [Treasury Liquidity Guaranty Program] yield curve extending past 3 years, that spreads on the TLGP debt will exceed 1% over Treasuries on the long end.  Why?  The spreads are in the 50-150 basis point region now for TLGP borrowers at 3 years, and if it were regarded to be as solid as the US Treasury, the spread would just be a small one for illiquidity.  (Note: the guarantee is “full faith and credit” of the US Government, but it is not widely trusted.  Personally, I would hold TLGP debt in lieu of short Treasuries and Agencies — if one doesn’t trust the TLGP guarantee, one shouldn’t trust a Treasury note — the guarantees are the same.)

One thing I am unclear on with respect to the financing on asset disposition: does the TLGP bondholder get his money back then and there when an asset is sold?  If so, the cashflow uncertainty will push the TLGP spread over Treasuries higher.

Thinking About it as an Asset Manager

There are a number of things to consider:

  • Sweet financing rates — 1-2% over Treasuries. Maybe a little higher with the TLGP fees to pay.  Not bad.
  • Auction?  Does the winner suffer the winner’s curse?  Some might not play if there are too many bidders — the odds of being wrong go up with the number of bidders.
  • What sorts of assets will be auctioned?  [Originally rated AAA Residential and Commercial MBS] How good are the models there versus competitors?  Where have the models failed in the past?
  • There will certainly be positive carry (interest margins) on these transactions initially, but what will eventual losses be?

The asset managers would have to consider that they are a new buyer in what is a thin market.  The leverage that the FDIC will provide will have a tendency to make some of the bidders overpay, because they will factor some of the positive carry into the bid price.

I personally have seen this in other thin market situations.  Thin markets take patience and delicate handling; I stick to my levels and wait for the market to see it my way.  I give one broker the trade, and let him beat the bushes.  If nothing comes, nothing comes.

But when a new buyer comes into a thin market waving money, pricing terms change dramatically after a few trades get done.  He can only pick off a few ignorant owners initially, and then the rest raise their prices, because the new buyer is there.  He then becomes a part of the market ecosystem, with a position that is hard to liquidate in any short order.

Thinking About it as a Bank

More to consider:

  • What to sell?
  • What is marked lower than what the bank thinks the market is, or at least not much higher?
  • Where does the bank know more about a given set of assets than any bidder, but looks innocuous enough to be presumed to be  a generic risk?
  • Loss tolerances — where to set reservation prices?
  • Does participating in the program amount to an admission of weakness?  What happens to the stock price?

Management might conclude that they are better off holding on, and just keep eating tasty elephant.  Price discovery from the auctions might force them to write up or down securities, subject to the defense that prices from the auctions are one-off, and not realistic relative to the long term value.  Also, there is option value in holding on to the assets; the bank management might as well play for time, realizing that the worst they can be is insolvent.  Better to delay and keep the paychecks coming in.

Thinking about it as the Government and as Taxpayers

Still more to consider:

  • Will the action process lead to overpriced assets, and we take losses?  Still, the banks will be better off.
  • Will any significant amount of assets be offered, or will this be another dud program?  Quite possibly a dud.
  • Will the program expand to take down rasty crud like CDOs, or lower rated RMBSand CMBS?  Possibly, and the banks might look more kindly on that idea.
  • Will the taxpayers be happy if some asset managers make a lot of money?  Probably, because then the government and taxpayers win.

Summary

This program is not a magic bullet.  There is no guarantee that assets will be offered, or that bids for illiquid assets will be good guides to price discovery.  There is no guarantee that investors and the government might  not get hosed.  Personally, I don’t think the banks will offer many assets, so the program could be a dud.  But this has some chance of success in my opinion, and so is worth a try.  If they follow my advice from my article Conducting Reverse Auctions for the US Treasury, I think the odds of success would go up, but this is one murky situation where anything could happen.  Just don’t the markets to magically reliquefy because a new well-heeled buyer shows up.

Add a New Chapter to the Bankruptcy Code, Redux

Tuesday, March 24th, 2009

Given the news of the morning, I thought I would dust off my four-month old proposal Add a New Chapter to the Bankruptcy Code.  Until we limit our dear government’s power to encourage the private sector to borrow money until it chokes, we need something that enables timely reduction of debt in TBTF (too big to fail) institutions, delevering them  with minimal impact to taxpayer and the rest of the economy.

This morning we have the following articles:

In my proposal, the Treasury Secretary would initiate the process, but then would get handed off to a special bankruptcy court for adjudication of claims.  The Treasury becomes the DIP lender, but otherwise is a minor player in the process.

Why not let the Treasury do it all?  Wouldn’t it be faster?  Yes, it would be faster, but at a price.  The current Bush/Obama administration policies have relied heavily on intelligent discretion from regulators.  We haven’t gotten that yet.  Even really intelligent regulators are men with limited time.  Even big organizations staffed with Ph.D. economists and other bright people like the Federal Reserve are less than the sum of the parts, as the bureaucracy enforces groupthink (and the Treasury is even worse).

When the Treasury Secretary or the Fed Chairman acts with discretion, there is always the charge of unfairness that can be laid at their doors.  Why is the credit of the US going to support special interests?  You say that it is for the good of the nation, but then why aren’t equity and preferred shareholders wiped out, management thrown out, and bondholders forced to compromise, and accept back equity in the new firm in exchange for their debt claims?

Our bankruptcy processes are transparent, fair, and even speedy (for what is being done) in the US; we just need to augment them for firms that pose risk to a large portion of the financial and economic systems.  But regulatory discretion in bailing out firms in this crisis has been a disaster.  Speed kills; a handoff to the bankruptcy court with the US Treasury backstopping the firm in the short run would be the best minimalist solution, stopping contagion, and allowing for an orderly resolution of competing claims under conditions transparent to the US taxpayer.

Leave AIG to its own Devices, and let it Fail if Need be

Tuesday, March 24th, 2009

When I was a young actuary, I worked for the now defunct Pacific Standard Life.  In 1984, PSL discovered Universal Life Insurance, and sold so much of it that it went insolvent, and was bought out of bankruptcy by Southmark.  I came to the company in 1986, but by 1988 I had my concerns.  Aside from the aggressive investment policy (junk bonds), Southmark had interlaced the capital of their subsidiaries, with one subsidiary owning the preferred stock of another, and vice-versa.  They even did a deal with ICH, exchanging preferred stock.  So long as neither defaulted, both looked more solvent, like two drunks holding each other upright.

My point for the evening is that there are clever ways to make an insurance company look more solvent than it should appear to be.  I mentioned the preferred stock manuever.  There are also deals regarding reinsurance.  A common traansaction is to sell of future profits in exchange for capital today.

Why do I write about this?  AIG again.  While I worked for the domestic life companies 1989-1992, I served as the actuary for the annuity line of business.  That involved the reinsurance treaties on annuities, which were designed to reduce the capital needs of the business, and thus increase leverage.  As I have sometimes said, “reinsurance is the ultimate derivative.”  If derivatives are opaque, reinsurance doubly so.  Tearing apart a reinsurance treaty is tough, and it takes significant skills that most auditors and regulators don’t have.

During my tenure at AIG, the reinsurance treaties were designed to decrease the capital needed to support the business.  Given the need for a 15% after-tax return on average equity (which was sometimes described as the “religion” of AIG), the easiest way to do it was to compromise the capital needed to support the business through reinsurance.  Equity goes down, ROE goes up.  That was the nature of AIG, and I could never be a lifer there because of the ethical problems I faced.

Now one of the assumptions that I have made about AIG is that the subsidiaries of AIG are well-regulated and solvent.  But why should I assume that things have gotten better since when I served in AIG?

If I had the Statutory data (regulatory accounting), I would look at all of the statutory statements of domestic insurers that AIG owns, and look for reinsurance and cross-shareholdings.  I would discount external reinsurance credits, and internal reinsurance I would check to make sure that reserves reinsured equal reserves insured.

If things are today like tkey were in the early 90s, I would expect to find the amount of capital needed to support the business compromised through reinsurance treaties.  Within a year, we will know if that is true.  There are some alleging large fraud here.

-==-=–==–=-=-=-=-=-=-=-=-=-=-=-=

Now, ther are other problems with the bailout of AIG, notably that it harms their competitors.  Government support may lead AIG to discount premiums because they don’t have to turn a profit in their current state.  This harms the rest of the industry.  Why should insurers with no government support have to battle an insurer with govenment support?

Also, as I have said before, there is no reason to bail out AIG the holding company, which is what our dear government has done.  We only care about the operating insurers, not the company that owns them.  For the nonregulated entities inside AIG, the only one that has a material impact on the rest of the world if AIGFP.  Guarantee this if the US government must, but stay out of the rest of AIG.  Let that go into insolvency, there is no compelling reason tfor the US to protect it with tax monies.

AIG — There are Many Criminals Here

Friday, March 20th, 2009

It could probably be shown by facts and figures that there is no distinctly native American criminal class except Congress.
- Pudd’nhead Wilson’s New Calendar
(from twainquotes.com)

There are many upset over the bonuses paid to AIG employees, most notably politicians seeking to curry favor with voters.  That these bonuses were known to the Fed, and the Treasury Department does not matter to many.  They see their tax dollars being taken by people who destroyed their own company, and they are angry at those getting the bonuses.  Better they should be angry at those who bailed them out, and who oversee the Fed — Congress.  That was the biggest crime.  By keeping AIG alive, they faciltated the crime they now decry, because bonuses would have disappeared in bankruptcy.

There was a better way, as I have written about before.  If there were systematic risk issues, guarantee the derivatives counterparty, and send the rest of AIG into Chapter 11.  The operating insurers and other financial companies would survive; those invested in the holding company (common and preferred) would lose their investments, and bondholders would have to compromise and receive equity in the new firm.

Is that what we did?  No, we invested in, and lent money to the holding company.  Money going to a holding company can go anywhere inside the network of companies (pay bonsuses, for example), whereas money to a subsidiary stays there until  conditions are good enough that dividends can be paid to the holding company.

In order to convince the Government that the recent  bailout of AIG was crucial to the financial system, they submitted this paper to the Fed and Treasury.  I’ll comment on it, page by page.

Page 2) They talk of a failure of AIG being a systemic risk when it is only the derivatives counterparty that is such.

Page 3) Same error, though the need to post capital is a reason why the holding company is insolvent.  That AIG would lose some of its foreign subsidiaries is no concern of the US Government.  Also, there would be no need to sell pieces of AIG if it were in Chapter 11.

Page 4) They overstate the life insurance systemic risk.  Yes, there is risk, but typically policyholders have to give up a great deal in order to surrender.  Their operation life insurance companies are likely healthy, but if not, the State Guaranty funds are around to protect things.  AIG is big in life domestically, and a failure would hurt, but not kill the life insurance industry.  The real risk is in the financial guaranty business, through AIG Financial Products, which is not regulated.

Pages 5, 6 ) Totally overstated.  Not likely at all.  AIG’s life subsidiaries are not that critical to the US economy.

Page 7) AIG is big, so what?  The regulated subsidiaries should survive.  Unregulated subsidiaries, aside from AIGFP, pose no systemic risk.

Pages 8-10) Overstated, and false.  The operating insurers are safe.  Let the parent company fail.

Page 11) Who cares if a consumer lender goes down — there is no systemic risk there.

Pages 12-16) Not relevant — those subsidiaries are solvent.

Pages 17-18) Relevant and true — AIGFP poses systemic risk.  But no concern for the Muni market — that will survive even without AIG.  Besides, why would they sell, even in insolvency?

Page 19) So ILFC is big — that does not mean it poses systemic risk.  The airlines will own the planes directly, if they can’t lease them.

Page 20) Sorry, the assets of the US Government and the Fed are already lost — they should not have bailed out AIG.

Page 21) Don’t overrate the importance of the insurance industry, and especially not AIG.

=-=-=-=-=-=-=-=-=-=-=-

AIG bamboozled the US Government (Fed/Treasury) into bailing them out.  Aside from their derivatives counterparty, there was no systemic risk associated with AIG.  The foreign subsidiaries are foreign, and should not be a concern of the US Government.  The domestic insurance subsidiaries are regulated by the states, and should be solvent.  If not, the guaranty funds will pick up the slack.

There was no reason to bail out AIG as a whole, and there remains no reason to continue to do so.  Congress has no one to blame but itself in the current brouhaha over bonuses at AIG.  They could have done it differently.

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.

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