Structured Products and Derivatives – Page 25

To What Degree Were AIG?s Operating Insurance Subsidiaries Sound? (6)

Posted on 29 April 2009 by David Merkel

Realized Capital Losses, Excluding Securities Lending at the Life Companies

Subsidiary	Sum of 2007YE Surplus	Other Realized Capital Losses / Surplus
First SunAmerica LIC	501	-81%
The Variable Annuity LIC	2,838	-61%
AIG Annuity IC	3,729	-49%
Am Int LIC of NY	553	-41%
AIG LIC	440	-39%
American General L&A IC	471	-28%
SunAmerica LIC	4,716	-17%
American General LIC	5,704	-16%
American Life IC	6,718	-11%
Merit LIC	705	-4%
Pacific Union Assurance Co	67	-1%

If the securities lending losses weren’t enough, the life companies ran asset portfolios where many risks did not pan out.

Much of that came from corporate bonds (including junk bonds), CMBS, and non-conforming RMBS.? The domestic life companies pruned areas of their portfolios in order to prevent greater losses later.

Book Review: Two Books on Options by Anthony Saliba

Posted on 23 April 2009 by David Merkel

I’m usually pretty open to reviewing books.? Sometimes I get books that I can’t do justice to in reviewing.? The following two books may be examples of that:

Option Spread Strategies: Trading Up, Down, and Sideways Markets

Option Strategies for Directionless Markets: Trading with Butterflies, Iron Butterflies, and Condors

I’m not an options trader.? Do I understand the math? Largely, yes.? Do I understand how they can benefit investors?? Also yes.? I occasionally use options to enhance income, but for the most part, I avoid using them for personality reasons.? I fear that I would make bad decisions while working at a higher level of leverage.? I don’t trust myself.

As for the books, they are clear and well-written, giving both the common view of options, and the view using the “greeks” a la Black-Scholes.? The chapters explain, and then offer tests at the end to see how well you have understood.? These could be textbooks in a business school.

The books explain how you can make money in any environment if your view of the world is correct.? That’s the catch, though.? Few of us get it right within the length of time before an option expires.? Be wary of the correctness of your opinions.

Now, my opinion is not of the highest value here.? Better to consult Adam Warner or Bill Luby, who have far more practical experience on a retail level.? My experience is largely institutional with respect to options.

PS ? Remember, I don?t have a tip jar, but I do do book reviews.? If you enter Amazon through a link on my site and buy things from them, I get a small commission, and you don?t pay anything extra.? If you wanted to get it anyway, it is good for both of us?

Nonidentical Twins: Solvency and Liquidity, Redux

Posted on 4 April 20095 April 2009 by David Merkel

Another post deserving a brief update: Nonidentical Twins: Solvency and Liquidity.? The accounting rules have changed on mark-to-market accounting, but it won’t help financials at all, because now the accounting will be distrusted.? Even Goldman Sachs, who covertly runs our government, 😉 believes that is so.? Cash flows talk, and estimates of future free cash flows drive stock prices.? Accounting rules do not affect free cash flows, and the best accounting systems try to make earnings approximate free cash flows.

Here’s one more difficulty with changing the accounting standards: companies have the choice when they buy an asset of labeling it held to maturity, available for sale, or a trading asset.? The accounting varies depending on the choice, but held to maturity means that there is no mark-to-market.? So why didn’t financial firms tag assets to be held to maturity?? Because if you sell too many assets so tagged, your auditors get annoyed, and would try to compel you to tag all of them as available for sale, at which point mark-to-market applies.

So, let’s take a trip to Bizarro-world, where companies never have to do asset impairment, ever.? You can hold a security at par even after it has declared bankruptcy.? Only when the bankruptcy settlement payment is made in cash or new securities, would the value change on the balance sheet.? How would investors in bank stocks operate in Bizarro-world?

For one, during times of credit market stress, they would significantly reduce the price-to-book multiples that they would be willing to pay for banks.? Book values aren’t trustworthy without impairment done on a good faith basis.

There is no free lunch with accounting rules.? Make them more liberal, and investors become more conservative.

Many bank managers might say, “It’s a money good asset; if I hold it long enough, I will get par.? Why should I be penalized today?”? They should be penalized for two reasons:

The probability of getting par back has declined.
The ability of the bank to hold the asset to maturity has declined.

The first reason is simple enough.? The second reason is not well-understood.? Those that argue against mark-to-market accounting implicitly assume that all financial institutions have the capability of holding until the asset matures (pays off in full).? But that is not always true.? Many seemingly strong financial institutions (rated AAA or AA!) — recently found they could not hold their assets to maturity.? If a bank has to raise liquidity prematurely, those mark-to-market prices (if done fairly, which I think is rare) reflect the true value of the assets.

This is why I believe that most liquidity problems are really solvency problems, but the banks are clinging to old prices, and don’t want to admit that things have changed.? As we joked at AIG domestic life companies back in the early 90s: “Oh, almighty actuary! Utter the weasel-words that allow this rusty tub to stay afloat so that we can continue to draw on our salaries!”? (Yeh, it was that bad in that unit then.? The rest of the company was better, supposedly.)

Substitute? the word accountant for actuary, and that is what the present fair value rules are creating.? What it means is that a company must break due to a lack of cash flows before it goes insolvent.? That puts our accounting on the level of Madoff and other Ponzi schemes.? No one is broke until there isn’t a dollar left in the till.

It’s a lousy way to do business, but investors will adjust, and lower valuations.

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

Posted on 31 March 2009 by David Merkel

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

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

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

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

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

-==-=-=–==–=-=-=-==–=-==-=-=-

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

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

The Great Omission

Posted on 27 March 200927 March 2009 by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

Covering Financial Institutions That May Pose Systemic Risks

i. A Triggering Determination

ii. Choice Between Financial Assistance or Conservatorship/Receivership

Options for Financial Assistance

Options for Conservatorship/Receivership

iii. Taking Advantage of FDIC/FHFA Models:

Requiring Covered Institutions to Fund the Resolution Authority

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

The Great Omission

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

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

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

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

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


		David Merkel
		The Fed Vs. GSEs: Which Is Most Threatening to the Economy?
		2/24/04 1:35 PM?ET
I found Dr. Greenspan’s comments about Fannie and Freddie this morning a little funny. I agree with him that the government-sponsored entities, or GSEs, have to be reined in; they are creating too much implied leverage on the Treasury’s balance sheet. They may prove to be a threat to capital market stability if they get into trouble; they are huge. Well, look to your own house, Dr. Greenspan. As it stands presently, the incremental liquidity that the Fed is producing is going into housing and financial assets. The increase in liquidity has led to low yields, high P/E ratios and subsidized issuance of debt. All of this has led to stimulus for the economy and the equity and bond markets, but at what eventual cost? The Fed has far more systemic risk to the economy than the GSEs. No stocks mentioned

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

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

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

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

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

Addendum

Praises

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

Problems

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

Liquidity and the Current Proposal by the US Treasury

Posted on 24 March 2009 by David Merkel

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

Many markets are not supposed to be liquid.

Why?

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

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

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

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

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

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

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

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

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

The US Treasury Proposal

The basics of the recent US Treasury proposal is this:

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

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

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

Thinking About it as an Asset Manager

There are a number of things to consider:

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

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

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

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

Thinking About it as a Bank

More to consider:

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

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

Thinking about it as the Government and as Taxpayers

Still more to consider:

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

Summary

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

AIG — There are Many Criminals Here

Posted on 20 March 200920 March 2009 by David Merkel

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

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.

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.