11 March 2009 – The Aleph Blog

Opportunities in Bank Bonds, Part 2

Posted on 11 March 200912 March 2009 by David Merkel

Thinking about Citigroup and Bank of America — Given to Finacorp Clients 3/4/09

When the government gets involved in business, the rules of the game change. Creditworthiness becomes less of an ?analyze the metrics? affair, and more of a ?how strong of a guarantee? affair. What would it take to make the US Government change the way that it is behaving?

But first, how have the US Government, Citigroup and Bank of America been behaving? I?m going to begin this with timelines for Citigroup and Bank of America. Things have happened fast, so a review of how we got to this stage in the crisis could be instructive in where things might go from here.

Citigroup Timeline

1. 9/29/08 ? C agrees to buy WB?s banking business. WFC offers more, but C?s offer is backed by FDIC. (Share Price prior to news ~ $20, afterwards $18.)

2. 10/9/08 ? C abandons bid to buy WB?s banking business. (Share Price prior to news ~ $13, afterwards $14.)

3. 10/14/08 ? C receives $25 billion in TARP money. (Share Price prior to news ~ $16, afterwards $19.)

4. 10/16/08 ? C reports 3Q net loss of $2.8B. (Share Price prior to news $9.52, afterwards $8.89.)

5. 11/17/08 ? C announces plan to lay off 52,000 workers. (Share Price prior to news $8.89, afterwards $8.36.)

6. 11/18/08 ? Mike Mayo predicts that C could lose money in 2009. (Share Price prior to news $8.36, afterwards $6.40.)

7. 11/19/08 ? C forced to take SIVs back on balance sheet after $3.3B losses. (Share Price prior to news $6.40, afterwards $4.71.)

8. 11/23/08 ? US Government invest $20B in C, and guarantees $306B of their liabilities. Fitch downgrades rating to A+. (Share Price prior to news $3.77, afterwards $5.95.)

9. 12/2/08 ? C sells $5.5B of FDIC-backed debt. (Share Price prior to news $6.45, afterwards $7.22.)

10. 12/19/08 ? S&P cuts C?s rating by two notches to A. Moody?s cuts C?s rating by two notches to A2.

11. 1/13/09 ? C sells brokerage unit for $2.7B to MS. Most C units are rumored to be up for sale. (Share Price prior to news $5.60, afterwards $5.90.)

12. 1/16/09 ? C reports $8.3B loss, announces plan to split in two. (Share Price prior to news $3.83, afterwards $3.50.)

13. 1/20/09 ? C slashes dividend to .01/share. (Share Price prior to news $3.50, afterwards $2.80.)

14. 1/23/09 ? C is effectively nationalized, argues Bloomberg. Increasingly, as a ward of the US Government, C increases lending, and home loan modifications.

15. 2/27/09 ? C announces a goodwill writedown of $9.6B, adding $9B to the losses of 4Q08. US Government enters a deal to convert $25B of preferred stake to common, pari with private institutional investors, increasing C?s tangible capital, and raising US ownership to 36%. Moody?s cuts C?s rating by two notches to A3. (Share Price prior to news $2.46, afterwards $1.50.)

Bank of America Timeline

1. 1/11/08 ? BAC agrees to buy CFC. Regulators offer BAC capital relief, letting them lend more to their broker-dealer subsidiary. (39.41 — 38.50)

2. 1/24/08 ? No capital will need to be raised after a $12B sale of preferred stock. (36.83 ? 40.57)

3. 3/10/08 ? Allegations of fraud and growing mortgage losses swirl around CFC. BAC affirms that the purchase will go through. (37.13 ? 35.31)

4. 4/21/08 ? BAC misses earnings as bad debt gets written down $6B. Moody?s cuts ratings of BAC to Aa2. (37.79 ? 37.61)

5. 5/15/08 ? CEO Ken Lewis criticizes the bailouts of Wall Street firms. (Sorry, couldn?t resist.) Aside from Bear, at that time, it was mostly Fed lending programs. (36.88 ? 36.71)

6. 5/21/08 ? BAC sells $2.7B of preferred stock. (35.40 ? 34.63)

7. 6/2/08 ? CEO Lewis calls the CFC deal compelling. (33.84 ? 33.58)

8. 6/19/08 ? Price of CFC deal adjusted down. (28.46 ? 28.14)

9. 7/1/08 ? CFC deal closes. (23.31 ? 23.81)

10. 7/8/08 ? CEO Lewis announces that the dividend will be maintained, and there is no need to raise more capital. (21.56 ? 23.54)

11. 7/16/08 ? Fitch cuts BAC rating two notches to A+. (19.45 ? 22.67)

12. 7/21/08 ? BAC beats estimates for 2Q08. Also announces that it does not plan to guarantee the debts of CFC. (27.85 ? 32.35)

13. 9/10/08 ? KBW cuts BAC to underperform, citing constrained capital. (32.97 ? 32.40)

14. 9/15/08 ? BAC agrees to buy MER for $44B as Lehman goes into Chapter 11. S&P cuts BAC?s rating to AA-. (28.23 ? 26.55)

15. 10/6/08 ? BAC misses 3Q estimates, cuts the dividend, and announces an offering of common stock. (29.65 ? 23.77)

16. 10/8/08 ? BAC raises $10B through selling common stock. (23.33 ? 19.63)

17. 10/16/08 ? MER announces fifth straight quarterly loss of $5.1B. (24.41 — 24.25)

18. 10/30/08 ? BAC announces a $15B issue of preferred stock to the US Government under the TARP program. $10B for Merrill (23.31 ? 22.78)

19. 11/18/08 ? CEO Lewis says MER acquisition is on track. (15.17 ? 15.19)

20. 12/5/08 ? BAC sells $9B of FDIC-backed debt. (13.90 ? 15.24)

21. 12/11/08 ? BAC announces job cuts of 35,000. (16.33 ? 14.91)

22. 12/19/08 — S&P cuts BAC?s rating to A+. (14.07 ? 13.80)

23. 1/2/09 ? BAC closes MER deal. (13.92 ? 14.33)

24. 1/7/09?BAC sells $2.8B of China Construction Bank stock. (14.11 ? 13.71)

25. 1/8/09 ? Moody?s cuts ratings of BAC to Aa3. (13.82 ? 13.54)

26. 1/16/09 — $138B lifeline extended by the US Government — $20B more of preferred stock, and guarantees on assets and derivatives equal to $118B. BAC cuts dividend to 1 cent/share. (7.18 ? 5.10)

27. 1/23/09 ? John Thain fired as Merrill loses $15.4B for 4Q08. (5.37 ? 6.24)

28. 2/20/09 ? CEO Lewis says that the finances of BAC are fine, and they don?t need additional help. (3.61 ? 3.79)

29. 2/24/09 ? CEO Lewis says that BAC is stronger than rivals. (4.03 ? 4.73)

30. 2/25/09 ? CEO Lewis says that Countrywide and Merrill will be stars in 2009. (You can?t make these up.) (4.81 ? 5.16)

31. 3/3/08 — S&P cuts BAC?s rating to A. (3.95 ? 3.65)

I bolded the cases where government actions were taken. What common factors can be found in the actions of the government?

Unwillingness to harm bondholders. Common and preferred stock can be diluted/destroyed, but not unsecured debtholders, not even junior ones.
The US Government is willing to give up protections for taxpayers if it would save institutions that they deem ?too big to fail.?
They are willing to give the money to the holding companies, rather than protecting operating banks and other regulated financials.
The US Government is willing to do it in pieces, with grumbling, but they will keep doing it until the US economy either normalizes, or falls apart.
The economic incentives of the banks become muddled with the goals of the government. More money is available to those that support the goals of the government, rather than only profits.

I think that the government?s actions encourage the laziness of bankers ? why sell assets when you can finance them? Why try to eke out profits when the government feeds additional liquidity to those that do their bidding?

As I said in my last article, there is some political pressure to make the bondholders of some of the holding companies share in the pain. I don?t think that will be effective in the short run for two reasons:

Inertia ? DC is slow to change even strategies that seem not to be working.
Large bond managers (e.g., PIMCO, BlackRock) that are providing many services to the US Treasury regarding the TARP have large holdings of senior debt, and they will do all they can to tell policymakers that it is a bad idea to have senior debt be compromised. It would have large systemic risk implications! Possibly, there is regulatory capture going on in the boldest way ever. Bond managers, representing the bond market, tell the US Treasury what they should do. Shades of the Clinton Administration.

Personally, I don?t think that the balance sheet of the US Government is big enough to handle all of the liabilities that they will be asked to absorb, equitize, or guarantee. Bondholders need to watch for stresses and strains that will appear in the currency and Treasury security markets, and be prepared for the day when the US Government says, ?No more. We can no longer afford this largesse. No one is too big to fail. Chapter 11 and RTC 2 for all failed financial companies.?

That is the main risk here, but it should not appear for a while. Gauge your own willingness to play in the bonds of firms like Citigroup and Bank of America. Without continued help from the US Government, they are insolvent; current prices factor in support for some time, but if that help should evaporate, prices will drop considerably. Dancing near the edge of a cliff is rarely advisable, even if you get paid to do it. Play this carefully.

Greenspan the Excellent Obfuscator

Posted on 11 March 200911 March 2009 by David Merkel

When I did my “Blame Game” series, I put Alan Greenspan near the top of the list for his mismanagement of monetary policy over his tenure, always bringing back the punch bowl too fast, and never letting enough marginal entities go into insolvency.? His tenure corresponds to the fast climb in the total leverage of the US economy.? When debtors realize that the Fed will not deliver any real pain, they quickly pile on the debt, leading to the overleveraged condition we are experiencing now.

In a WSJ editorial today, Greenspan has the temerity to say that his monetary policy did not cause the housing bubble:

There are at least two broad and competing explanations of the origins of this crisis. The first is that the “easy money” policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today’s financial mess.

The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.

First, small differences in correlation coefficients are not adequate to test a hypothesis.? Second, the low Fed funds rate touched off a flurry of adjustable-rate home loans, which Greenspan himself inadvisably endorsed at one point.? The adjustable rate loans became a much larger part of the residential mortgage space than ever before.? Greenspan does not cite figures for his mortgage rate claim — I am guessing that he is comparing fixed rate mortgages to Fed funds, which is not the right metric here, given the large amount of floating rate issuance.

U.S. mortgage rates’ linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.

As I noted on this page in December 2007, the presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.

As I noted at RealMoney during 2004-2006, the yield curve flattened the hard way, with the Fed raising rates, and the long end falling.? I noted that China was acting as a second central bank for the US, stimulating as the Fed withdrew stimulus.? But the Fed did little to counteract China’s influence; they could have been more aggressive, and acted faster.? They could have tightened margin requirements or bank capital requirements.? They just plodded, and continued to let overall leverage in the economy get out of whack.

Low global interest rates were just a sign that the global marginal efficiency of capital was eroding.? There was overinvestment, and not enough understanding in the neomercantilistic countries to realize that they were flooding the world with their goods, as their purchasers flooded them with credit.

Yes, the credit policies of other nations were a factor, but it does not excuse the mismanagement of monetary policy by Greenspan, where private and public debts were allowed to build up to record high ratios of GDP, threatening the health of the financial system, and the Fed did little to nothing about it.