Structured Products and Derivatives – Page 33

Entering the Endgame for Monetary Policy

Posted on 26 September 200826 September 2008 by David Merkel

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.

2300 Smackers

Posted on 26 September 2008 by David Merkel

We’re talking stimulus, right?? And we trust the American People, right?? Why not just send each American household $2,300 for each man, woman, and child there?? Let them decide how the $700 billion stimulus should be used.? What, you say, it should diminsh debt?? But our dear government is doing nothing of the kind.? They are borrowing massively from China and OPEC.

What’s that, you say?? That doesn’t help the banks?? Well, why help the banks unless it helps the people?? So why not help the people directly, and maybe it will help the banks.? You believe in the free market, which means individual choice, right?

Sigh.? Our government believes nothing like this.? They intervene to protect their patrons, the financial institutions, while dissing the taxpayers, and that is how it goes.

Let the Current Bailout Die

Posted on 26 September 2008 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.

Call Their Bluff

Posted on 24 September 2008 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.

Oppose The Treasury’s Bailout Plan

Posted on 20 September 200820 September 2008 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:

Here is the proposed bill
Here is a summary of the main points of the bill
Here is a relatively neutral article from the Wall Street Journal on the issue.
And another from Marketwatch
Finally, a blog post from Paul Krugman, opposing the bill. (If Paul Krugman and I agree on something, there is something weird going on.)

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:

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

Posted on 13 September 2008 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….

The Banking Industry Should Learn from the Insurance Industry

Posted on 2 September 2008 by David Merkel

I can’t comment on everything, at least above the degree of quality that I try to impose on myself.? (I know, the standards could be raised. 😉 )? But I did want to comment on a paper on banking capital regulations that came out of the Jackson Hole conference.? Odd Numbers and Naked Capitalism commented on it, and I thought both had good things to say.? I have my own twist to share, having been a risk manager inside two insurance companies.

The basic idea of the paper is that risk levels have to be reduced at banks, but banks want to stay highly levered so that they can earn high returns on equity, so asking them to reduce debt levels or internal leverage is not feasible.? Instead, why not have them buy insurance policies that pay out during banking crises?? Then they will have the capital when it is needed, and they can continue to lend in all environments.

(SIgh.)? I have oversimplified their arguments, but I have done it to help make some points, which are:

1) The cost of the insurance policy will get factored into the equity calculation for return on equity, at least at far as a prudent bank manager would view it.? The insurance policy is illiquid, and its cost should be reckoned as a part of the surplus it replaces, which may allow for a reduction in overall surplus levels carrying the business.? (Note to regulators: anytime you allow a financial entity a reduction in required surplus from a risk transfer agreement, you should analyze the alternative of using the premium(s) paid to add to surplus, and ask, which looks better.? Also, these are collateralized agreements, but in uncollateralized agreements, analyze the counterparties, and deny surplus credit frequently.)

2) Do the authors realize how expensive these agreements should be?? Consider:

The insurer is asked to post the collateral, which takes money out of its surplus.
The insurer is asked to be ready to lose an asset at a very bad point in the credit cycle.
The monies are invested in Treasury securities, so there is no possiblity for the insurer to make money from investing the premium more aggressively, but still safely.
Large banking crises happen about once every 20 years or so, with smaller ones more frequent.? With a long enough agreement, the loss of the Treasury collateral is almost certain, making the cost high.
If these were common, a sort of moral hazard would develop, similar to what has happened with the financial guarantors.? Banks would conduct business aggressively, realizing that they have the capital backstop.? Initial results would look good, until the crisis. Then, double surprise! The insurers figure out that they didn’t charge enough for the insurance, and the banks find out that their losses were larger, because of their aggressive behavior.? Wound banks be willing to pay premiums around 5-15% of the face amount insured, depending upon where the risk trigger kicks in?

3) Beyond that, there would probably be a scarcity of providers.? Few want to dedicate a large portion of their capital bases to the events that are entirely a process of human action.

Take a lesson from the reinsurance industry.? Ideally, you would want an agreement that took the risks directly off of your books, such that the capital would come when you specifically had losses above a threshold.? That’s been done in the insurance industry for reinsuring companies as a whole, and the reinsurers have usually come off the worse for it.? The insurers almost always know their risks better than the outsiders.? Reinsurers prefer to reinsure specific risks that they can underwrite, not companies as a whole.

But, lest I merely seem to be a critic, let me offer three suggestions for how to try to make this work.

1) Call Ajit Jain at Berkshire Hathaway.? They have the capital.? Give him a detailed proposal of what you want, and let him give you the quote that makes your jaw drop, or, watch him decline the business, unless you put your bank into a straitjacket of terms and limitations of coverage.

2) Try setting this up through an Industry Loss Warranty.? You would get paid capital during bad times if the industry has suffered losses past a threshold, and you have suffered losses in excess of a threshold as well.

3) Or, try setting this up as a catastrophe bond.? Borrow money through the bond at a high rate of interest.? Junk bond buyers will fund you.? During a crisis, if the banking industry losses exceed a threshold, the principal of the notes gets written down, and voila!? You have capital when you need it.? Note that the junk bond buyers should require more of a premium here, because bank losses tend to be correlated with other junk bond losses — no big benefit from diversification here.

I will leave aside the idea of setting up captive reinsurance sidecars, because those are just regulatory arbitrage.

My main point here is that I don’t think that this type of insurance will work.? Even for those willing to contemplate the structure, the true price will be too high for the banks to gain any benefit.? Perhaps this could be done on a limited basis for one more turn of the credit cycle, but I think for those that offer the insurance, the banks that buy it, and the regulators, they will be less than happy with the results.

In my opinion, we need to bring down leverage ratios for the banks, slowly but inexorably.? If that hurts their ROEs, well, I’m sorry.? If we are going to do a leveraged fiat money system, the leverage must be considerably lower than where we are now, and all synthetic exposures (derivatives) must be brought on balance sheet as if they were cash transactions.? It is that lack of transparency and increase in leverage that has made our financial system so much more risky, as this other paper from the Jackson Hole conference states.? I did not feel that the discussants really understood what they were talking about, because they could see the micro level risk reductions from derivatives, but miss the added leverage, lack of transparency, and concentration of risk in the hands of parties that were greedy for yield, and may not be able to make good on all agreements in a crisis.

Much complexity and leverage will need to be unwound before this credit crisis is over.? The era of high ROEs for banks should be over for some time, that is, until the regulators fall asleep again during the next boom phase.? Some things rarely change.

The Fundamentals of Residential Real Estate Market Bottoms

Posted on 29 August 200820 June 2017 by David Merkel

This article was posted at The Big Picture this morning as I was guest-blogging for Barry.? That’s a first for me, and there is no better site to do it at.? I present the article here for those that did not see it at The Big Picture.

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This piece completes a series that I started RealMoney, and continued at my blog.? For those with access to RealMoney, I did an article called The Fundamentals of Market Tops, where I concluded in early 2004 that we weren?t at a top yet.? For those without access, Barry Ritholtz put a large portion of it at his blog.? I then wrote another piece at RM applying the framework to residential housing in mid-2005, and I came to a different conclusion: yes, residential real estate [RRE] was near its top.? Recently, I posted a piece a number of readers asked me to write: The Fundamentals of Market Bottoms, where I concluded we weren?t yet at a bottom for the equity markets.

This piece completes the series for now, and asks whether we are at the bottom for RRE prices. If not, when, and how much more pain?

Before I start this piece, I have to deal with the issue of why RRE market tops and bottoms are different.? The signals for a bottom are not automatically the inverse of those for a top. Tops and bottoms for RRE are different primarily because of debt investors.? At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.? There is a sense of invincibility for the RRE market, and the financing markets reflect that. Bottoms are more jagged, with debt financing expensive to non-existent.

As a friend of mine once said, ?To make a stock go to zero, it has to have a significant slug of debt.?? The same is true of RRE and that is what differentiates tops from bottoms.? At tops, no one cares about the level of debt or financing terms.? The rare insolvencies that happen then are often due to fraud.? But at bottoms, the only thing that investors care about is the level of debt or financing terms.

Why Do RRE Defaults Happen?

It costs money to sell a home ? around 5-10% of the sales price. In a RRE bear market, those costs fall entirely on the seller. That?s why economic incentives for the owners of RRE decline once their equity on a mark-to-market basis declines below that threshold. They no longer have equity so much as an option on the equity of the home, should they continue to pay on their mortgage and prices rise.

As RRE prices have fallen, a larger percentage of the housing stock has fallen below the 10% equity threshold. Near the peak in October 2005, maybe 5% of all houses were below the threshold. Recently, I estimated that that figure was closer to 12%. It may go as high as 20% by the time we reach bottom.

Defaults occur in RRE when there would be negative equity in a sale, and a negative life event occurs:

Unemployment
Death
Disability
Disaster
Divorce
Large mortgage payment rise from a reset or a recast

The negative life events, which, aside from changes in mortgage payments, can?t be expected, cause the borrower to give up and default. During a RRE bear market, most people in a negative equity on sale position don?t have a lot of extra assets to fall back on, so anything that interrupts the normal flow of income raises the odds of default. So long as there are a large number of homes in a negative equity on sale position, a certain percentage will keep sliding into foreclosure when negative life events hit. For any individual, it is random, but for the US as a whole, a predictable flow of foreclosures occur.

Examining Economic Actors as We near the Bottom

Starting at the bottom of the housing ?food chain,? I?m going to consider how various parties act as we get near the RRE price bottom. At the bottom, typically Federal Reserve policy is loose, and the yield curve is very steep. Financial companies, if they are in good shape, can profit from lending against their inexpensive deposit bases.

This presumes that the remaining banks are in good shape, with adequate capacity to lend. That?s not true at present. Regulation has moved into triage mode, where the regulators divide the institutions into healthy, questionable, and dead. The bottom typically is not reached until the number of questionable institutions starts to shrink. Right now that figure is growing for banks, thrifts, and credit unions.

The Fed?s monetary policy can only stimulate the healthy institutions. Over time, many of the questionable will slow growth, and build up enough free assets to write off bad debts. Those free assets will come through capital raises and modest profitability. Others will fail, and their assets will be taken over by stronger institutions, and losses realized by the FDIC, etc. The FDIC, and other insurance funds, will have their own balancing act, as they will need to raise premiums, but not so much that it harms borderline institutions.

Another tricky issue is the Treasury-Eurodollar [TED] Spread. Near the bottom, there should be significant uncertainty about the banking system, and the willingness of banks to lend to each other. Spreads on corporate and trust preferreds should be relatively high as well. Past the bottom, all of these spreads should be rallying for surviving institutions.

Financing for purchasing a house in a RRE bear market is expensive to nonexistent, but the underwriting is strong. At the bottom, volumes increase as enough buyers have built up sufficient earning power and savings to put a decent amount down, and be able to comfortably finance the balance at the new reduced housing prices, even with relatively high mortgage rates relative to where the government borrows.

Many other players in RRE financing will find themselves stretched, and some will be broken. Consider these players:

1) Home equity lenders will be greatly reduced, and won?t return in size until well after the bottom is passed.

2) Many unregulated and liberally regulated lenders are out of business. The virtue of a strong balance sheet and a deposit franchise speaks for itself.

3) Buyers of subordinated RMBS have been destroyed; same for many leveraged players in ?high quality? paper. Don?t even mention subprime; that game is over, and may even be turning up now as vultures pick through the rubble. This has implications for MBIA, Ambac, and other financial guarantors, since they guaranteed similar business. How big will their losses be?

4) Mortgage insurers are impaired. In earlier RRE bear markets, that meant earnings went negative for a while. In this case, one has failed, and some more might fail as well.

5) Do the GSEs continue to exist in their present form? That question never came up in prior bear markets, but it will have to be answered before the bottom comes. Will the FHLB take losses from their mortgage holdings? Will it be severe enough that it affects their creditworthiness? I doubt it, but anything is possible in this down cycle, and the FHLBs have absorbed a lot of RRE mortgage financing.

6) Securitization gets done limitedly, if at all. This is already true for non-GSE-insured loans; the question is how much Fannie and Freddie will do. My suspicion is near the bottom, as loan volumes increase, banks will be looking for ways to move mortgages off of their balance sheets, and securitization should increase.

7) The losses have to go somewhere, which brings up one more player, the US Government. Through the institutions the US sponsors, and through whatever m?lange of programs the US uses to directly bail out financially broken individuals and institutions, a lot of the pain will get directed back to taxpayers, and, those who lend to the US government in its own currency. It is possible that foreign lenders to the US may rebel at some point, but if the OPEC nations in the Middle East or China haven?t blinked by now, I?m not sure what level of current account deficit would make them change their policy.

That said, the recent housing bill wasn?t that amazing. Look for the US Government to try again after the election.

A Few More Economic Actors to Consider

Now let?s consider the likely actions of parties that are closer to the building and buying of houses.

1) Toward the bottom, or shortly after that, we should see an increase in speculative buying from investors. These will be smarter speculators than the ones buying in 2005; they will not only not rely on capital gains in order to survive, but they require a risk premium. Renting the property will have to generate a very attractive return in order to get to buy the properties.

2) Renters will be doing the same math and will begin buying in volume when they can finance it prudently, and save money over renting.

3) At the bottom, only the best realtors are left. It?s no longer a seemingly ?easy money? profession.

4) At the bottom, only the best builders survive, and typically they trade for 50-125% of their written-down book value. Leverage declines significantly. Land gets written down. JVs get rationalized. Fewer homes get built, so that inventories of unsold homes finally decline.

As for current homeowners, the mortgage resets and recasts have to be past the peak at the bottom, with the end in sight. (In my piece on real estate market tops, I suggested that after the bubble popped ?Short rates would have to rally significantly to bail these borrowers out. We would need the fed funds target at around 2%.? Well, we are there, but I didn?t expect the TED spread to be so high.)

5) Defaults begin burning out, because the number of the number of properties in a negative equity on sale position begins to decline.

6) Places that had the biggest booms have the biggest busts, even if open property is scarce. Remember, a piece of land is not priceless, but is only worth the subjective present value of future services that can be derived from the land to the marginal buyer. When the marginal buyers are nonexistent, and lenders are skittish, prices can fall a long way, even in supply-constrained markets.

For a parallel, consider pricing in the art market. Many pieces of art are priceless, but the market as a whole tends to follow the liquidity of the rich marginal art buyer. When liquidity is scarce, prices tend to fall, though it is often masked by a lack of trading in an illiquid market.

When financing expands dramatically in any sector, there is a tendency for the assets being financed to appreciate in value in the short run. This was true of the Nasdaq in the late ’90s, commercial real estate in the mid-to-late 1980s, lesser-developed-country lending in the late ’70s, etc. Financing injects liquidity, and liquidity creates confidence in the short run, which can become self-reinforcing, until the cash flows can?t support the assets in question, and then the markets become self-reinforcing on the downside, as buying power collapses.

The Bottom Is Coming, But I Wouldn?t Get Too Happy Yet

There are reasons to think that we are at or near the bottom now:

Sales are increasing in a number of areas where foreclosures are significant.
What little lending is being done is being done on relatively sound terms.
Securitization has slowed dramatically.
The major homebuilders do trade for 50-125% of book value, generally. The question is how much remains to be written down.
New home sales have slowed dramatically. Homebuilder confidence is low and construction has slowed.

But I don?t think we are there yet, and here is why:

Foreclosures are still increasing.
Mortgage stress seems to be increasing in prime and prime jumbo loans.
The inventory of unsold homes continues to rise. At the bottom, inventories will have started to shrink, but are not yet to normal inventory levels. (There is also significant dark supply, or shadow inventory as well.)
The inventory of depository financial institutions in trouble continues to rise. Regulatory triage is only beginning.
We still have a lot of payment resets and recasts to go through. (My, but the option ARMs are ugly now.
FOMC policy is not providing a lot of liquidity to the economy as a whole, but only to a few lending markets.
The future of the GSEs, mortgage insurers, and financial guarantors are still up in the air.
The US Government will try some more policy ideas after the election.
We aren?t seeing a lot of speculative buying yet.
The biggest booms have had the biggest busts, but affordability is yet to be restored in what were the hottest markets.

My best guess is that we are two years away from a bottom in RRE prices, and that prices will have to fall around 10-20% from here in order to restore more normal price levels versus rents, incomes, long term price trends, etc. Hey, it could be worse, Fitch is projecting a 25% decline.

Not all of the indicators that I put forth have to appear for there to be a market bottom. A preponderance of them appearing would make me consider the possibility, and that is not the case now.

Some of my indicators are vague and require subjective judgment. But they?re better than nothing, and keep me in the game today. Avoiding the banks, homebuilders, and many related companies has helped my performance over the last three years. I hope that I ? and you ? can do well once the bottom nears. There will be bargains to be had in housing-related and financial stocks.

Full disclosure: no positions in companies mentioned

Finance When You Can, Not When You Have To

Posted on 23 August 2008 by David Merkel

“Get financing when you can, not when you have to.”? Warren Buffett said something like that, and it is true.? My biggest early investment loss was Caldor, which Michael Price lost a cool billion on.? A retailer that could not hold up to Wal-Mart, Target, and Sears, Caldor expanded in the early 90s by scrimping on working capital.? Eventually a cash shortfall hit, and their Investor Relations guy said something to the effect of, “We have no financing problems at all!”? The vehemence cause the factors that financed their investory to blink, and they pulled their financing, sending Caldor into bankruptcy, and eventually, liquidation.

Caldor had two opportunities to avoid the crisis.? It could have merged with Bradlees and recapitalized, leaving it stronger in the Northeastern US.? It also could have done a junk bond issue, which was pitched to them eight months before the crisis, but they didn’t do it.? In the first case, the deal terms weren’t favorable enough.? In the second case, they thought they could finance expansion on the cheap.

Caldor is forgotten, but the lessons are forgotten today as well.? Today, overleveraged financial companies wish they had raised equity or long-term debt one year ago, when the markets were relatively friendly and P/Es were higher, and credit spreads were lower.

I know I am unusual in my dislike for leverage in companies, but on average less levered companies do better than those with more debt.? Caldor went out with a zero for the equity.? A few zeroes can really mess up performance.

Capital flexibility has real value to good management teams.? I don’t mind exess cash hanging out on the balance sheets of good firms.? Hang onto some of it, and maybe during a crisis you can buy a competitor at a bargain price.

But for the financials today, who has the wherewithal to be a consolidator?? Most of the industry played their capital to the limit, and are now paying the price.? Either the door is shut for new capital, or they are paying through the nose.

I don’t see anyone large who fits that bill of being a consolidator.? Maybe some of the large energy companies that have been paying down debt would like to diversify, and buy a bank.? Hey, feeling lucky?!? Lehman Brothers!

Look, I’m being a little whimsical here, but the point remains — run your companies with a provision against adverse deviation.? Be conservative.? For those that invest, avoid companies that play it to the limit, unless you are an investor with enough of a stake that you can control the company.

Banking on Continued Risk in Lending Markets

Posted on 22 August 2008 by David Merkel

I like to think that I have a pretty strong stomach for risk.? I am used to losses.? I have my sell disciplines, and I act on them.? I also try to be forward-thinking about risk; not just reacting, but trying to anticipate what the markets are likely to deliver.? Every now and then, I get a surprise.? Here’s the surprise, which I got from The Big Picture (Barry’s blog).? Institutional Risk Analytics does some good work, and this article is representative of their work.? In it, they describe the two risks facing the large banks — risks from their assets, and risks from their derivative books.

The second link made me pause.? I know things are bad, and I can’t vouch for Institutional Risk Analytics’ risk based capital model for banks, but the level of notional derivatives exposure at many of the major banks to their tier 1 surplus made me pause.? There are two claims on surplus — losses from direct lending, and losses in the derivative books.

Those who have read me for a long while know that I think the derivative books at the investment banks are mismarked and possibly mishedged.? When accounting rules are not well-defined, and instruments are illiquid, even well-meaning managements tend to err in their favor in the short run.

This is significant in a number of ways, but the main one was pointed out in the first link, that with the continuing failure of small banks, how will the FDIC make depositors secure if a large-ish institution fails, when reserves are relatively low?? They need to raise their fees that they charge solvent banks to replenish their coffers.? They are also bringing back retirees with experience in dealing with insolvent banks.

So, are the banks in trouble?? Some of them are experiencing stress, and that is coming through higher credit spreads on their debt.? Given the higher costs entailed in funding for banks, it is all the more important in your investing to look for companies that don’t need much external finance.? After all, many banks may find it harder to lend.? Consider the difficulties in funding InBev’s purchase of Anheuser-Busch.? Large banks are straining at their limits.? They don’t have enough parties to sell loans off to, nor do they want to hold onto so much of the risk.

The bank loan and and bond markets are closely connected.? Troubles in one tend to spill over to the other.? Loans have a higher priority claim, so the yields are lower than for bonds.? As it is, investment grade corporate bonds, particularly financials, are facing higher yields.? The high yield market has slowed considerably.

So, what does this imply?? The banks are hunkering down.? They are scrutinizing all risk exposures.? They aren’t expanding lending, which is showing up in MZM, M2, and my M3 proxy.? Credit is getting tough/sluggish.

And the degree of leverage that banks are willing to use versus the Fed’s monetary base is dropping, and hard (the graph covers 28 years).

So, I’m not optimistic here. I believe in the value of “long only” money management as having better chances of risk control than hedged strategies, but this is making me queasy. What it makes me think, is that the FOMC’s next move is a loosen. It hurt to say that, particularly given my dislike of inflation, but the solvency of the financial system comes ahead of inflation in the Fed’s calculus, even though loosening won’t help much.

With that, I am looking to continued problems in banks, and perhaps for the economy as a whole.? Our next president will have a fun time with this…