Category: Real Estate and Mortgages

Back to One-Off Bailouts

Back to One-Off Bailouts

Posted on by David Merkel

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

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

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

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

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

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

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

A couple of notes before I close:

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

What A Fine Mess You Have Gotten Us Into

Posted on by David Merkel

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

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

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

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

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

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

Three notes to close:

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

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

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

Entering the Endgame for Monetary Policy

Entering the Endgame for Monetary Policy

Posted on by David Merkel

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

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

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

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

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

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

Let the Current Bailout Die

Let the Current Bailout Die

Posted on by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Don’t Rush It

Don’t Rush It

Posted on by David Merkel

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

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

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

Call Their Bluff

Call Their Bluff

Posted on by David Merkel

Twice in 2002, and once in 2001, I engaged in a risky form of financial behavior.? I was an investment grade corporate bond manager, and I was focused on financial names.? In 2001, post 9/11, we bought all of the out-of-favor sectors from September to November.? (I remember being at a conference for insurance CIOs in October, and seeing the horrified looks on the face of the other CIOs in a closed door session, when I said we were expanding our exposure to BBBs and junk, and hotels, Airplane EETCs, etc.? What topped it all was the representative from Conseco telling me how irresponsible I was.? Coming from Conseco, that made me blink.)

But we sold them all in the second quarter of 2002, when the hunger for yield was growing.? We happily sold our bonds that were now in favor for higher prices.? Then, with the accounting disasters at mid-year, on July 27th, two of my best brokers called me and said, “The market is offered without bid.? We’ve never seen it this bad.? What do you want to do?”? I kept a supply of liquidity on hand for situations like this, so with the S&P falling, and the VIX over 50, I put out a series of lowball bids for BBB assets that our analysts liked.? By noon, I had used up all of my liquidity, but the market was turning.? On October 9th, the same thing happened, but this time I had a larger war chest, and made more bids, with largely the same result.

At that point, I noted that the market was behaving differently.? Most of the troubled names were either dead or cleaned up, so I continued to buy yieldy long-duration financial bonds as the rally continued.? Aside from a hiccup as the Iraq war started, the rally that started October 9th persisted for a long while in equities and corporates.

Why am I telling this story?? Partly because the case for panic conditions in the fixed income markets, and with the banks is thin.? By the time we were in mid-2002, the equity markets were down far more from the peak, and implied volatilities were a lot higher.

Now, what is different at present is that the losses in this market are being led by financials, because in 2002 housing was not overvalued like it is today, and in 2002, the commercial and investment banks were not so highly levered.

So, looking at the two periods, I would rate the economic stress as pretty even across the worst of 2001-2002 and now.? We bounced back from 2002 without any bailouts.? Could it get worse from here in this present era of stress?? Yes, it could.? But at some level, enterprising investors come in without the aid of the government and begin buying assets where the downside is adequately discounted, and the upside ignored.? We are close to that now, with mortgage opportunity funds starting up.? Those won’t see the light of day if there is a bailout.

So, I’m not sure we need any bailout.? As Yves Smith at Naked Capitalism notes, the calls from average people to Capitol Hill are having an impact.? Keep making them.? Call the Treasury’s bluff.? If we prove wrong, well, the next administration will craft its own measures, rather than a bunch of unaccountable lame ducks who are unaccountable even when not lame ducks.? (Did I say that?? Sigh.? Repeat after me: This is not a political blog, this is not a political blog… and I voted for Bush twice, not that it matters much in Maryland.)? I agree with Naked Capitalism again — there may not be a true crisis.

But, I can look at it from another angle.? If I had $700 billion to spend as a clever investor (versus $30 billion for Buffett, earning 17% lending to Goldman Sachs), what would I do?? I would adopt the same approach that I did in 2002 (where my war chests were hundreds of millions), and get my analysts to percolate up their best ideas, and do rough estimates of what fair value is at a number of different discount rates.? I would start small, and offer lowball bids for hundreds of millions of seemingly mispriced securities.? I would adjust my bids as I found no takers or many takers.? Price discovery in illiquid bond markets is tough, but it is something I was good at in 2001-2003.? I would also leave markets where there is no rationality… I can invest anywhere, why should I limit my reach?? If Buffett can earn 16-17% off of Goldman Sachs, why should I look for much less?

Today, Bernanke suggested the use of reverse auctions to deploy bailout money at hold-to-maturity pricing levels.? My dear naive professor, markets avoid equilibrium, they do not seek equilibrium.? When the markets are in trouble, most players are in trouble, and there is not enough liquidity to bring the markets to long-run equilibrium levels in the short run.? The fundamental value of an asset is a relative concept, and depends on factors like the yield curve, implied volatility/credit spreads, etc.

The danger with the Treasury bailout proposals is that they will waste money by buying assets at levels above what the market will bear.? The danger with Dodd’s proposal is that they will drive companies into the ground through dilution from hasty asset sales.

Looking at it from a static standpoint, perhaps $5 Trillion would solve the crisis.? I think that would fill every hole, definitely.? But on a dynamic basis, you don’t need as much to move markets.? Once a buyer of size comes in, other players adjust their bids and asks.? So, if I had $700 billion of cash, I would have a hard time disguising my moves.? I would expect to send unused cash back to my funders.

Also, the difficulty of reverse auctions when you have so many disparate securities with small sizes is tough.? So, I look at this crisis, and think that if we wait for four months, the situation might be better, and no bailout will be needed.? If not, the next administration, not lame duck, would face the consequences.

Our Manic Markets

Our Manic Markets

Posted on by David Merkel

The markets are manic.? It is rare that we have so many large moves in a short time.? Consider these graphs:

Gold

Gold is rising since the bailout announcement.

So are crude oil prices.

And the US Dollar falls.

Swap spreads rise.

And mortgage rates rise also.

Forces larger than the US government are acting on the world economy, leading to a partial repudiation of the US Dollar by some foreign entities.? This leads to higher implied volatility in the equity markets, and higher credit and swap spreads.? Commodity prices rise also. Would you want to own the securities of a country that overpromised what it would deliver in terms of debt repayment?

I think not, and the present economic environment is decidedly hostile to fixed US Dollar denominated assets.? Play in the US dollar with care… the short trade has much to commend it in the intermediate term, though the short term is cloudy.? Also, be careful on the long end of the US fixed income market… it could deliver some significant negative surprises.

We Need Oversight, and Compensation to the Taxpayers

We Need Oversight, and Compensation to the Taxpayers

Posted on by David Merkel

Here are the issues as I see them in the bailout:

  • The Treasury can’t do it as if they are autocrats.? The powers of the other branches of our government should not be curtailed here.? The Treasury should submit to oversight from Congress and be subject to the Judiciary.? Fortunately, it seems like that is happening.
  • Second, if you are going to bail out firms that are still alive, you must ask them for equity stakes that are somewhat punitive.? The Dodd bill does that, and though there are areas where I might disagree, it is a lot fairer to the American taxpayer than the original Treasury proposal.? Bailouts should always be painful, making the rescue a last resort.? (Note, in the Dodd plan, the key weakness is that the finances of the firm selling distressed assets to the government might will likely see its stock price weaken after the purchase, leaving not enough protection by the time of sale.? But it is better than the Treasury proposal.)
  • Third, the bailout still needs a way to deal with insolvent institutions.? The Resolution Trust Corporation was a way to deal with those problems.? It’s possible that a new entity could absorb the assets of failed financial institutions, but given the nature of regulated companies, deciding on the proper transfer price is difficult.

We are on slippery ground here, and I’m not sure that the market would react badly if no plan were put in place.? A bad plan is worse than no plan, and I believe the market fell on Monday because the original Treasury plan was horrid.? If something like Dodd’s plan were enacted, I think the market would rally, even with its deficiencies.? We need oversight, and compensation to the taxpayers.

To all my readers, I still say, contact your Congressmen and Senators, and tell them to stand up to the Treasury, and demand compensation for any bailout, and if no compensation, we only bail out insolvent firms.? Bailouts must hurt.

PS — For an entertaining view of one possible future as we socialize the financial system, read this piece from the ever-wise Caroline Baum.

Oppose The Treasury’s Bailout Plan

Oppose The Treasury’s Bailout Plan

Posted on by David Merkel

This is not a political blog.? I have political views, but I try to keep them out of my writing here, because they aren’t relevant to my readers.? This is a rare point where the two worlds collide, and I have to take a political stand.

Let me state this plainly at the beginning of my piece, so that you know where I am going: I am asking all of my readers, and all of the financial bloggers that read me (whether here or at Seeking Alpha) to call their Congressmen, and ask them to oppose the Bailout Plan as currently structured.? I am also asking the financial bloggers to ask their readers to do the same thing. I don’t do things like this often, so understand that I think that this bailout plan is very ill-conceived.? I also think that opposing the bailout should appeal to all, regardless of party affiliation.

Okay, now let me explain why, and propose an alternative.? Some links to begin:

As I stated in my last blog post:“The possibility of a new RTC could be a good or a bad idea.? The main criterion is whether it is proactive or reactive.? My answer my surprise many: reactive is good, proactive is bad.

What we don?t want to do is provide a place for companies to dump lousy assets at inflated prices.? Instead, a new RTC should be a last resort place that the assets of failed companies go to until they are disposed of.? Common and preferred equity should be wiped out, and bondholders should take haircuts.? New loans should be senior to all old loans, similar to the situation with AIG.

Anyone going to the new RTC should feel pain, and a lot of it.? It should be the last resort for companies that are failing.? It should not try to keep companies alive, but merely conserve the value of assets, and prevent contagion.? Remember, if the risk is not systemic, the government should not try to bail it out.”

The current proposal is proactive.? Proactive solutions are expensive, and do not fairly distribute the losses to those who caused them through their shoddy lending practices.? The owners of bad assets should risk their equity before taxpayers put up one red cent.? The government should not try to prevent financial failure, but prevent financial failure from spreading as a contagion.? Common and preferred stockholders of failed institutions should be wiped out.? Subordinated debtholders should take a haircut.? But depositors and senior debtholders should be guaranteed, in order to protect other financial institutions that invest in those instruments, thus avoiding contagion effects.

Second, the proposed bill is vague, and offers the Treasury a “blank check” to do pretty much what it wants.? Section 8 states: “Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.” Who are we kidding here?? I don’t care how great the emergency may be, the other branches of government should be able to act as needed.

Third, there is nothing to assure that fair market value will be paid for assets.? If an investment manager is hired, who could tell if he plays favorites or not?? Clever investment firms will take advantage of the government and its agents, and only sell overpriced assets to the government.

Fourth, there is no easily identifiable upside for taxpayers here.? If we bail out a firm, it should be painful, as it was for the GSEs and AIG, where most of the equity gets handed over to the government in exchange for a senior loan guarantee.

Fifth, though the name of the Resolution Trust Corporation has been invoked here, this is nothing like the RTC.? The RTC only dealt with insolvent S&Ls.? It did not try to keep existing S&Ls afloat.

This proposal is an expensive boondoggle and should be opposed by all.? As one bit of evidence here, how many noticed that mortgage rates went up on the day the deal was announced?? Here is a graph for Fannie 30-year fixed-rate mortgages:

x

The announcement of a bailout may have caused mortgage credit spreads to shrink, but it caused Treasury yields to rise even more. The announcement was not a positive for the mortgage market, and my guess is that it will get worse from here.

My Solution

Bring back the Resolution Trust Corporation, for real.? Don’t do deals with solvent institutions.? Let them figure out how to best maximize their financial positions on their own; after all, it was their great decisionmaking skills that got them into this.

But do do deals with insolvent companies.? Take in their illiquid assets, reposition them, and auction them off once they are more saleable.? To the extent that we bail out whole firms, make it so costly to the firms that it is clearly a last resort, as with Fannie, Freddie, and AIG.

I am willing to testify before Congress on this issue, not that I think that will happen.? If anyone from Congress happens to read this and wants me to testify, please contact me here.

Finally, to any readers or financial bloggers that take me up on my request, I offer you a hearty thanks. 🙂

Investing in Financial Stocks is Tough

Investing in Financial Stocks is Tough

Posted on by David Merkel

At RealMoney, I wrote an article in 2005 called, Buyers Beware: Financials are Different.? In addition to many other things I mentioned there, I gave six ways that financials were different:

  • Tangible assets play only a small role in a financial company. What constrains the growth of an industrial company? The fixed assets (plant and equipment) limit the technical amount of product that can be delivered in a year. Demand is the ultimate limiting factor, but this affects financial, industrial and services businesses alike. But with a financial company, sometimes the limits are akin to a service business (“If only we had more trained sales reps”), but more often, capital limits growth.
  • The cash flow statement plays a big role with industrials and utilities, but almost no role with financials. One of the great values of the cash flow statement is the ability to attempt to derive estimates of free cash flow. Free cash flow is the amount of cash that the business generates in a year that could be removed with the business remaining as functional as it was at the start of the fiscal year. Deducting maintenance capital expenditure from EBITDA often approximates free cash flow. Cash flow statements for financials cannot in general be used to derive estimates of free cash flow because when new business is written, it requires capital to be set aside against the risks. Capital is released as business matures. In order to derive a free cash flow number for a financial company, operating earnings would have to be adjusted by the change in required capital.
  • Sadly, the change in required capital is not disclosed anywhere in a typical 10K. Depending on the market environment, even the concept of required capital can change, depending on what entity most closely controls the amount of operating and financial leverage that a financial institution can take on. Sometimes the federal or state regulators provide the most constraint. This is particularly true for institutions that interact closely with the public, i.e., depositary institutions, life and personal lines insurers. For entities that raise their capital in the debt markets, or do business that requires a strong claims-paying-ability rating, the ratings agencies could be the tightest constraint. Finally, and this is rare, the probability of blowing up the company could be the tightest constraint, which implies loose regulatory structures. Again, this is rare; many companies do estimates of the economic capital required for business, but usually regulatory or rating agency capital is tighter.
  • Financial institutions are generally more highly regulated than non-financial institutions. There are several reasons for this: the government does not want the public exposed to financial risk or systemic risk; guarantee funds are typically implicitly backstopped by the government (think FDIC, FSLIC, state insurance guaranty funds, etc.); and defaults are costly in ways that defaults of non-financials are not. The last point deserves amplification. In a credit-based economy, confidence in the financial sector is critical to the continued growth and health of the economy. Confidence cannot be allowed to fail. Also, since many financial institutions pursue similar strategies, or invest in one another, the failure of one institution makes the regulators touchy about everyone else.
  • Rapid growth is typically a negative. Financial businesses are mature, and there is a trade-off between three business factors: price, quantity and quality. In normal situations, a financial institution can get only two out of three. In bad times, it would be only one out of three.
  • Because of the different regulatory regimes, financial institutions tend to form holding companies that own the businesses operating in various jurisdictions. Typically, borrowing occurs at the holding company. The regulators frown at borrowing at the operating companies, unless the borrowers are clearly subordinate to the public served by the operating company. This makes the common stock more volatile. In a crisis, the regulators only want to assure the safety of the operating company; they don’t care if the holding company goes bust and the common goes to zero. They just want to make sure that the guaranty funds don’t take a hit, and that confidence is maintained among consumers.

In general, accruals are weaker than cash entries in accounting.? Not all accruals are created equal either.? Some are less certain to be collected/paid, and some are further out in the future than others.

Financial stocks are generally bags of accrual entries in an accounting sense, with some more certain than others.? E.g., a short-tail personal lines P&C insurer’s accounting is a lot more certain than that of an investment bank.

This is why management quality matters so much with financial stocks.? The managements of financial companies must be competent and conservative, and all the more so to the degree that the accruals that they post are less certain.? Companies that grow too rapidly, or lack obvious risk control are to be avoided.

Looking at the Present Concerns

I own a bunch of insurance companies, but no banks or other financials.? Why?? Insurers are profitable and cheap, and are not under threat from credit risk to the degree that other financials are.? Consider the threats to AIG, Citi, Lehman, Merrill, GM, Ford, Wamu, etc.? The companies that got into trouble grew too fast, levered up too much, neglected risk control disciplines, and more.

Now their valuations have been crunched, and their financing options are limited.? Fortunately there are the options of last resort:

  • Have you maxed out trust preferred obligations? Other subordinated debt?
  • Have you maxed out preferred stock?
  • Have you issued convertible debt to monetize volatility?
  • Have you diluted your equity through secondary IPOs, rights offerings, PIPEs, and/or deals with strategic investors?
  • Have you sounded out investors in your corporate bonds about debt-for equity swaps?
  • And, unique to Fannie and Freddie, have you asked the US government for a capital infusion or a debt guarantee?

Given that Bear got a guarantee, perhaps others could too, though I think the US Government is far less willing now.? I could also add another point: have you sold your most valuable liquid assets?

With the crises being faced by financial companies, there is a rule that separates the survivors from the losers: Losers sell their best assets, and play for time.? Survivors/winners sell their worst assets and hunker down — they have enough financial slack that they don’t have to engage in panic behavior.

In an environment like this, where there is a lot of uncertainty, avoiding suspect financials is prudent.? This applies to those who take on the risks from such institutions when the decisions have to be made quickly on whether to buy them or not.? Thus I would be careful on the equities of any buyers in this environment, and would be a seller of any company that is a rapid buyer during this time of financial stress.

Full disclosure: no positions in companies mentioned.? I own SAFT LNC AIZ MET RGA HIG UAM among insurers, and might buy some more….

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