March 2009 – Page 2 – The Aleph Blog

At Assurant Investor Day

Posted on 19 March 200919 March 2009 by David Merkel

I own a number of insurers in my portfolio.? Each of them has hard-to-replicate business models, with strong cultures, and good management teams (excluding HIG, which is merely a speculation at present).? The tickers are listed below.

But Assurant is the best in my opinion.? Unlike many companies in the life space, their liabilities are stable.? Unlike many P&C insurers, their distribution model is inexpensive, and the downside is limited.? Unlike many health companies, by focusing on individuals and small groups, and not using “teaser rates,” they have had decades of constant profitability.? Unlike many life companies, if the S&P 500 goes up or down, they have no direct risk.

Earnings were in the $5+ range in 2007 and 2008.? They should be in the same range in 2009, and with Assurant, the grand majority of earnings are free cash flow, which means they can do dividends, stock buybacks, debt buybacks, do tuck-in acquisitions (they do it so well), take writedowns, take more risk with assets, fund growth, or just keep slack cash for future opportunities.? There are enough distressed assets out there, that I suspect they will do some small acquisitions and then grow them organically.

Asset problems are modest at Assurant relative to other life companies.? Because of their flexibility, they have made the sales and taken the writedowns early, rather than hanging on and hoping.? Are their assets loss-proof now?? Of course not, and I would encourage you to look at the CIO, Chris Pagano’s presentation — it’s “Low risk, not no risk.”

As Buffett would say, when he invests, he likes to have a moat — an unreasonable advantage that is hard for competitors to attack.? That is Assurant.? With the possible exception of Employee Benefits, they are #1 or #2 in every sector that they compete in.

And, they invest in their people, developing skills, leadership, etc.? I asked if they were still doing it now, and the CEO said it would be penny wise and pound foolish not to continue to do so.? Good company, I tell you, and few insurers do that, though PartnerRe has something like it (if they can’t write business profitably, they don’t write, and then spend time improving their skills and models).

So with a P/E of 4, a P/B of 73%, and a P/FCF near 5, I am very comfortable owning Assurant, and if the price dips again down to the recent lows, I will probably make it a double-weight in my portfolio.

PS — for those that have the capacity to buy 25-year debt, would you like an 11% yield on a well run company?? Buy AIZ debt as well.

Full Disclosure: long AIZ PRE SAFT RGA ALL and HIG (spit, spit)

The March FOMC Statement

Posted on 19 March 2009 by David Merkel

Below you will see my summary of the FOMC Statement and how it changed.? Before I give you that, let me summarize what I think the changes are, the market impact, and whether I think it will work.

The Changes

The Fed will expand its balance sheet massively, buying another $750 billion of agency mortgage-backed securities, $300 billion of long Treasuries, another $100 billion of Agencies, and expand eligible collateral for the TALF to include who knows what.
The crisis involves the real economy in a big way now, not just the financial economy.
The crisis is definitely global.
They have ceased to forecast when it will end.
They are pursuing recovery, not growth now.

The Market Impact

The Dollar fell roughly 2-3%.? Gold rallied 4%+.
The ten-year sector of the nominal Treasury curve fell the most in yield terms, around 50 basis points. Biggest rally since 1962.? The long end fell 30 basis points. Agencies outperformed Treasuries.? Mortgages lagged.
TIPS outperformed nominal bonds with the long end falling 40 basis points, and the 10-year 55 basis points, leading inflation expectations to rise.

Will this work?

I?m skeptical.? This is just a bigger shift of financial obligations from the balance sheet of financials to the Fed, at prices unfavorable to the Fed, because their own statements will make them buy dearly.? When they unwind these trades, they will take significant losses, eliminating seniorage income to the US Treasury.

Lowering Treasury, Agency and conforming mortgage rates, assuming that it can be done in the long run (not likely), will not help consumers or corporations.? Forcing a small spectrum of interest rates down does little for collateral values.? People are inverted on their debts, and this does not solve that.? You might get a few refinances out of that, but that?s all.? Credit card, auto, and other debts are unaffected, and the TALF is still pie-in-the-sky.? Can it work?? Corporate bonds, bank debt, Commercial real estate loans, etc. ? there is no effect.? It only makes life better for the US Government, Fannie, Freddie, the FHLB, and those seeking conforming mortgage loans.

There is no real debt reduction here, and debt levels are the cause of this crisis, not interest rates on the debt.? I don?t think this will work, but this is another case where ?the beatings will continue until morale improves.?? Ben Bernanke is too certain of what is the correct move, given his Ph.D. studies.? It would be better and simpler to follow an inflationary course that hits at the root causes of debt by giving every adult a $5,000 voucher good to pay off a debt to any regulated financial institution.? Consumers win, banks win, and foreign creditors lose.

Current Recommendation

I don?t think this rally will hold, so when upward momentum fails, sell long duration fixed income positions.

Fed Statements Compared

(I reordered the January Statement to make the compare better.)

January 2009 Information received since the Committee met in December suggests that the economy has weakened further.	March 2009 Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract.	My Thoughts Basically the same.
Industrial production, housing starts, and employment have continued to decline steeply, as consumers and businesses have cut back spending.	Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending.	There is a hint of deepening of the crisis, especially how falling asset values and diminishing credit affect behavior.
Conditions in some financial markets have improved, in part reflecting government efforts to provide liquidity and strengthen financial institutions; nevertheless, credit conditions for households and firms remain extremely tight.	Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment.	No hint of improving credit now. Lack of credit having real effects on business activity.
Furthermore, global demand appears to be slowing significantly.	U.S. exports have slumped as a number of major trading partners have also fallen into recession.	Recession abroad, not merely slowing.
The Committee anticipates that a gradual recovery in economic activity will begin later this year, but the downside risks to that outlook are significant.	Although the near term economic outlook is weak, the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth.	No longer forecasting a recovery this year. Near term outlook is weak.
In light of the declines in the prices of energy and other commodities in recent months and the prospects for considerable economic slack, the Committee expects that inflation pressures will remain subdued in coming quarters.	In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued.	Weakness is widespread and not contained by country or sector. Economic slack is here now, and not prospective.
Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.	Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.	Same
The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.	In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability.	No longer are they pursuing growth, but recovery.
The Federal Open Market Committee decided today to keep its target range for the federal funds rate at 0 to 1/4 percent. The Committee continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.	The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.	The Fed funds rate, now irrelevant, will stay irrelevant for a long time.
The focus of the Committee’s policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve’s balance sheet at a high level. The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.	To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.	What was a possibility now is coming. If all of it is executed, the Fed?s balance sheet will grow from $1.9 to $3.0 Trillion. Credit easing, the attempt to manipulate key market interest rates using Fed credit, will be the majority of Fed policy now.
The Federal Reserve will be implementing the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.	The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets.	TALF, should it get off the ground, will include rasty stuff that we never imagined the Fed would buy.
The Committee will continue to monitor carefully the size and composition of the Federal Reserve’s balance sheet in light of evolving financial market developments and to assess whether expansions of or modifications to lending facilities would serve to further support credit markets and economic activity and help to preserve price stability.	The Committee will continue to carefully monitor the size and composition of the Federal Reserve’s balance sheet in light of evolving financial and economic developments.	This isn?t just a financial markets crisis anymore. It is now affecting almost every part of the business world.

Ten Comments on the Current Market Melange

Posted on 17 March 2009 by David Merkel

1) I like PartnerRe — they invest in their people; they limit their risks; they keep their balance sheet strong.? So it was with pleasure when I saw they had bought back the majority of some of their their junior debt at 50+ cents on the dollar.? Good move.

2) The short-term performance model for financial stocks recommends insurance brokers and reinsurers here. No surprise, because both of them face little risk on the asset side of the balance sheet.? For insurance brokers, short?term performance favors BRO, AOC, and EHTH.? For reinsurers, short-term performance favors VR, RNR, GLRE, and AWH.? Personally, I would consider BRO and AWH. Very soundly run firms.

3) There are troubles with life insurers as noted in this WSJ piece.? Personal notes: I applied to be chief investment officer of Shenandoah Life in 2003.? They told me they needed to get more out of their asset portfolio.? I gave them some free consulting — I told them that their portfolio was fine, but that they had too many lines of business, and their expenses were too high.

Penn Treaty (spit, spit) — I know some of the management there; they were dealt a bad hand.? I fault the state insurance department of Pennsylvania for not taking them over four years ago, and allowing a reserve credit for a reinsurance treaty that did not pass risk.

As for Conseco and Genworth, it is just another demonstration of how long term care insurance is not an underwritable liability.? There is too much freedom for policyholders to influence benefits paid.

Then there are the equity-sensitive insurers, like Hartford, Lincoln National, and Phoenix.? They will have a very high beta versus the market, because they are on the cusp.? Sad place to be.

4)? Why are we trying to reassure China regarding their purchases of US Government debt?? As a government, they made efforts to push their exports on the US, and had to take back US debt, because it seemed to be the best store of value, or at least, the most liquid.? Personally, I do not see any reason to kowtow.? They are not our problem; we are their problem.? Let China figure out that they have been playing ina rigged casino.? They still don’t have many places to park spare funds.

5) I have a little more sympathy for Ben Bernanke after he appeared on 60 Minutes.? That doesn’t mean that I think he is right, but to see an honest man trapped in a situation where his gifted intellect is stunted because he has bought into a flawed paradigm is painful.? Worse is that he will drag us along with him.? That said, I find it laughable that the recession will end in 2009.? That’s just political talk to make us comfortable.

6) When the dollar and gold move together, it is a sign that the rest of the world is in worse shape than the US.? Frightening, huh?

7) As I have commented long before this, state and municipal pensions are in deep trouble, or worse the states and municipalities are in trouble.? It may add up to a lot of funds.? Also, they may have made a number of bad investments.

There were many years where some of the states rested on their laurels and did not put a cent into the pension coffers.? The surging market took care of their funding, wrong as that was to assume.? Now they are paying the price for their political indolence.

8 ) The flub.? Whoops, the FHLB. What, they invested in dodgy mortgage securities?? They are supposed to support the mortgage markets regardless.? Big surprise that they get whacked in this environment.

9) I am no big fan of fair value, but I detest those that want to modify FAS 157. The problems are due to bad investment decisions, not bad accounting rules.? Even with held-to-maturity accounting, there is loss recognition.? Investors are not dumb.? To the extent that losses are not recognized in the accounting, suspicion grows.

Accounting does not affect cash flows, and as such does not affect the valuation of firms.? Most major accounting studies reflect this truth.

10) Can you pass the CEO test?? Personally, I found this article to be edifying.? It describes what an effective/good CEO is.

Full Disclosure: Long PRE HIG

A Day in the Life of John Davidson, Part VI

Posted on 14 March 2009 by David Merkel

My apologies to readers for not completing this six weeks ago.? It’s not as if I did not know where I wanted to go, it was that things in my life and other aspects of the news led me to cover other things.? Here are the episodes so far:

I hope to complete this in 1-3 more episodes.? For those that want a program, here are the main characters, and I don’t think that I am introducing any more.? By the way, when I am done, I will publish this whole story as one long post.

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

-==–==–=-=-=-=-=-=-=-=-=-=-=-==–=-=-=-=-==–=-==-=–=

“Cash flow is the blood flowing through the circulatory system for businesses,” said Caleb Matmo.? “This is true of any sort of company, but with a financial company, the answer is tricky, because one has to take into account the change in capital required to support the business.? Also, with insurers, we try to equalize reserving, so that conservatism or liberalism gets stripped out.? This applies to both assets and liabilities.”

John thought about it.? “Hmm — I always said to my Chief Actuary, Greg, ‘No negative surprises.? We must not over-report earnings.’? Let’s see what happens next.”

Matmo continued, “Working with your actuarial staffs and with Peter, we have constructed a new accounting basis that reflects your ability to dividend to Mega.”

“Uh, oh,” thought John.

“But in the process, we have reflected standardized procedures for reserving, and capital levels as well.? Where the regulatory capital basis is too lenient we raised the level of capital necessary to support the business.? Companies should not dividend back funds necessary to support the business, even if the regulators might let them do it.? Think of the recent demise of your financial guarantee insurer as an example.? They sent ample dividends to the holding company, and all the while their business was deteriorating.”

John thought, “True enough.? So maybe dividends to Mega aren’t everything?…”

Stan Bullard said, “Mr. Matmo?? It’s time for a break.? After we come back, summarize your comments regarding each insurance subsidiary, and then Brad and I will take it from there, with your help.”

“Of course, Mr. Bullard.” said Caleb Matmo.

John got up and stretched.? He was bewildered at the turn of events, but he picked up the reports and headed to the Mens room.? “Time for analysis, but I need relief,” he thought.? The room went many different directions, but John ignored it.

They Voted For Change, They Got Bush-Plus

Posted on 13 March 2009 by David Merkel

Time flies on the Ron Smith show… it was supposed to be one hour, but he asked me to stay for two. The topic of conversation changed as well; we were going to talk about Greenspan’s editorial and how economists did not like Obama and Geithner’s performance so far. Instead, because the Madoff news broke, we talked about that and a flurry of other issues in our broken economy.

It was fun, and Ron is a very bright guy. We seem to have good chemistry, and that is one reason that I go to the studio rather than do it by phone. Eye contact is worth a lot; it aids our ability to interact. I will also say that our conversations off the air are very stimulating.

But that brings me to tonight’s topic. We did talk about Greenspan’s editorial briefly, but we never got to talk about the WSJ article, Obama, Geithner Get Low Grades From Economists.? That’s what I would like to address now.

Geithner and Obama got scores of 51 and 59 from the economists on a scale of 100.? Why might they have scored them this way?

The response has been slow.
The proposals are vague.
The proposals aren’t big enough.
The proposals are too big.
The bills are a crazy quilt of misbegotten earmarks.
The White House/Treasury hasn’t appointed the undersecretaries necessary to help Geithner.? What kind of incompetence during a crisis is this?
The effects of these proposals are too uncertain.

Now, Ben Bernanke received a much more favorable reception from the economists, with a score of 71.? Why the higher and different score?

Economists favor other economists — there is a bias toward those that understand the profession, whether they are competent or not.
They believe that Bernanke understands the Great Depression well, so he must have the right answers.
Bernanke is basically following the lead of Friedman and Keynes as he approaches these problems.? His actions are a test of neoclassical and Keynesian macroeconomics.
He acted quickly, even if it had no significant effect on the crisis.

Economists are loath to repudiate themselves.? They defend their discipline, even when it is tough to do.? Americans, by their nature, prefer action to inaction.? It is one of our failings.? So it is with the economists, and even more so.? They presume that some level of action with monetary or fiscal policy will get the economy out of the jam that we have self-manufactured.

Now, there is a broader question to ask, and it is, “Should economists be questioning Obama and Geithner, or should it be vice versa?? After all, the economics profession has not distinguished itself in the last two years.? Those that have gotten it right (like me and others) have been fringe elements in economics.? The Neoclassical school is in shambles, and now the Keynesians take the field in an effort to prove that they are right.? Both will fail, in my opinion.

Neoclassical economics, the dominant paradigm, does not understand how financial markets affect the economy.? The Keynesians assume that financial markets affect the economy, but that the effects are haphazard due to the “animal spirits” (irrationality) of businessmen.? With all of the advice from economists, you would think we would be closer to a solution by now, but due to disagreements, that is not the case.

As it is now, those that voted for Obama wanted change, but have ended up with an economic approach to the crisis that is basically Bush-plus.? Do everything that the Bush, Jr. Administration was doing, but do it bigger, with many earmarks peripheral to economic stimulus, but dear to Democratic constituencies.? Much of that money will be wasted and do little good for the economy.

But if only Nixon could go to China, if only Clinton could do NAFTA and welfare reform (with his arm twisted), if only Bush, Jr. could promise compassionate conservatism and deliver the Iraq war and spend like a maniac, then perhaps Obama could surprise us too.? I don’t care for his policies, but he is a bright guy.? Perhaps he could see past the the Neoclassical and Keynesian economists and choose something totally different.? Unlikely, though, because of all the economists appointed to different areas of his administration, many of whom have big reputations and egos.

This piece from the Washington Post spells out the situation well.? It looks like a “too many cooks spoil the broth situation,” where heavyweights neutralize each other, pulling in different directions favoring their own personal theories.? Odds are that leads to delay, and compromise solutions that do little good for the economy.

So, watch the current melange of policies continue, generating little positive effect on the economy.

On The Ron Smith Show Today

Posted on 12 March 200912 March 2009 by David Merkel

The invite came late today, but in the 4PM (Eastern) hour, I will be on The Ron Smith Show.? For those in the Baltimore area, that’s 1090 on the AM dial.? For those over the internet, go here, and click the “Listen Live” button.

What will we be talking about?? Alan Greenspan’s editorial that I replied to here, and which FT Alphaville picked up on twice.? (Incidentally, here is where my “Blame Game? (one, two) series is located.

Also, we will be discussing the WSJ article, Obama, Geithner Get Low Grades From Economists.? Now economists have enough egg on their faces from the current crisis, so maybe their ability to judge should be weighed in the balance as well.? I’m not crazy about the actions of the Fed or the Treasury during either the Bush, Jr. or Obama Administrations.? As with my Blame Game series — there is more than enough blame to go around.? The real question is whether policymakers aren’t digging us into a deeper eventual hole, which I think they are.

And then we’ll talk about whatever else the callers want to talk about.? It’s fun and fast — the hour just blows by.? More to come later — I have pieces on AIG, Berky, and a few other things in the hopper.

Oh, one more thing, from jck at Alea: U.S. Household Net Worth: Down $11.5 Trillion in 2008. I definitely questioned the growth in national net worth when I was writing for RealMoney.? My main argument was that incurring debt to buy the assets was artificially inflating their vale, and when debt levels normalized, net worth would drop as well.

Three Notes on Current Market Matters

Posted on 12 March 2009 by David Merkel

1) One year ago, I opined that there would be legal difficulties splitting the financial guarantee insurers into municipal and non-municipal businesses. Two articles, though I think I wrote more:

The powers that be tried to conspire, because it favored municipalities (them!).? Now a hedge fund with an economic interest sues to stop the split.? No surprise.? Why should debtholders allow themselves to be disadvantaged from the split?? Now, will the structured finance buyers step forward?

2) Will bondholders of “too big to fail institutions” take a hit?? I have thought so, but here is another article indicating an increase in political pressure there.

3) Should life insurers be bailed out? No.? Will the big life insurers be bailed out?? I think so.? The state guarantee funds rely on the solvent insurance industry to pay up, and if a lot of the big insurers fail, those guaratee funds will severely tax the surviving life insurance industry.? A sad situation, would that we would force life insurers to be more conservative in their leverage posture.

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.

Time Horizon Compression

Posted on 10 March 2009 by David Merkel

Before I start for the evening, I would like to point to another Stable Value is in trouble piece from a reputable source.? I never knew that AIG was 10% of the wrapper business.? Well, as I often say, “Seemingly free money brings out the worst in people.”

This piece will have echoes from my recent piece The Bane of Broken Balance Sheets, where I tried to point out why many assets are trading below equilibrium levels, but also why it is rational for them to be so valued, because of the lack of long-term financing capacity.? This piece will talk about shrinking time horizons, or equivalently, a rise in discount rates for distant and risky cash flows.

During recessions, people become more short term in their thinking.? It is even worse in depression conditions, as we are in now.? Average people become concerned for their jobs, and begin saving as a pad against the future.? Spending is not so free.? Things that are broken can be fixed or done without.? We can live with a dent here or a scratch there. Coffee?? I can make that myself.? Homemade bread tastes a lot better.

Given the implicit downward pressure on wages, people begin producing more at home, and more in informal areas of society, where the ability of the taxman to reach in is reduced or non-existent.? Now when average people are so concerned about their current expenses, do you think they are in a mood to take investment risks?? Not at all.? Money is needed with near certainty.? Even tax-advantaged vehicles like 401(k)s and IRAs are targets for raiding.? The concept of retirement becomes quaint, fueled by the large birth cohort attempting to do it, versus the smaller prior birth cohorts that society could easily handle.

Sorry, but someone has to do the work, and to have too many aiming to retire in a nation that does not save is not possible.? So there are many with inadequate savings that are pulling back, and realizing that they will have to work until they die, or are incapacited.? Social Security won’t swing it, and in another 10-15 years, benefits will begin to be reduced in real terms, because the economy will not be able to bear it.

Now, someone might (tactlessly) say, “Okay, so poor working schmoes will have to work until they die.? Big deal for the capital markets, because they are marginal players there.”? For one with more delicate sensibilities, I would point them to the subprime mortgage market in 2006, of which I wrote a timely piece.? Who cared about subprime?? It was less than 1% of the mortgage market.? Well, true, but it would have an impact on housing prices as resets happened, and would be the straw that broke the camel’s back, leading to a self-reinforcing decline in housing prices.? The poor working schmoes are the first to get hurt when the cycle turns, but they certainly aren’t the last to be hurt.

Corporations shepherd their liquidity as well in such a crisis, and think less of long term projects with less certain rewards, but instead look at things that can affect the bottom line now.? Cutting projects, workers, etc., will aid the bottom line.? Small acquisitions of technologies and marketing channels that can be grown organically may work.? Dividends and buybacks may not work.? Cash might have to be conserved.

Private equity faces a situation where debts need to be serviced, but business is slow, and contributions from limited partners are not forthcoming.? Even the private equity players become more short-term in their orientation.

Equity managers hold onto more cash.? Prime brokers extend less leverage.? Banks become more particular with underwriting standards.? In everything there is more of a desire to preserve the present than to build the future.

This is what we get for years of mindless monetary policy where everyone trusted in the “Greenspan Put.”? After years where liquidity would be thrown at every small problem, now we are in a situation where there is little liquidity to throw at big problems.? We overleveraged the system — of course there is no liquidity until the system is delevered.? Liquidity only exists when leverage is stable or being built up.? When leverage declines, there is no liquidity.

In such a situation as this, we should expect compression of P/E, P/B, and other ratios.? We should expect high yields on corporate and high-yield bonds.? Are stocks cheap?? Yes, but they will probably get cheaper, because we don’t have a lot of liquidity to bid for them.

This cycle will turn when the cash flow yield of assets reaches levels people can make money on in the worst environments; where equity funds new projects with no debt, and the profit is obvious.? We’re not there yet by any means.? Perhaps 20% or so lower, we will find a bottom.