1) The Modigliani-Miller Theorem asserts that the value of assets at a firm is independent of how they are financed.? The dirty truth is that less levered public firms are more profitable, and generally better investments than highly levered public firms.? Why?? High levels of debt often lead managements to think short-term, and they make more errors.? Yes, some firms will do amazing things when the debt gun is pointed at their head.? More will fail, or muddle.? Perhaps this is a place where private equity does better than heavily indebted public companies, because they are out of the spotlight.? Equity Private, if you are listening, what do you think?
2) Too many foxes, not enough rabbits?? Perhaps true for now.? There is a lot of money in vulture funds relative to the opportunities at present.? That might change as we get near the nadir of the credit crisis, but it does set up an interesting dynamic.? If you were managing a vulture fund, when would you deploy your cash?? It’s a tough decision — too early, and you don’t get the good deals, and the same if you are too late.? Personally, I would do a time-scale, and allocate relatively evenly over the next 18 months.
3) Counterparty risk is still a threat.? Well, sort of.? The investment banks are pretty sharp at limiting their own risks to their clients.? The real risks are the willingness of the investment banks to offer credit to each other.
4) Securitization will come back.? It is too powerful of a technology for it not to come back.? The only question is when.? Deals are still getting done where the GSEs guarantee the risk.? Beyond that, little is getting done.? Better disclosure will help in the long run, but in the short run, it doesn’t mean much.
5) The credit crisis is over!? Well, not according to Caroline Baum and David Goldman.? Both are acquaintances of mine.? Many know Caroline Baum, whose ability to explain the Fed and the credit markets is superior.? David Goldman is less well known, but this is what I wrote at Barry’s site today:
David Goldman is a bright analyst and underrated. I met him back when he was with First Boston, and I was a mortgage bond manager. His commentary at CSFB and BofA helped make me a better investor.
I don’t normally push multimedia, but I thought the interview was a good listen.
6) Default rates are rising on junk grade corporates.? Odds are they will be higher still in 2009.? When junk grade default rates move up, it is typically for three years or so, and in this case, we have more low-rated debt as a percentage of the market than at any time in the past.? Is it possible that we could eclipse the default rate of 2002?? Yes, but I would not put a lot of money on that; I feel the odds are 50/50.? Many corporations are highly levered but prospering from global demand, not US demand.
7) As I suggested regarding ACA Capital Holdings, they ended up owned by their policyholders, who get an equitable interest in the assets of the company, though not enough to settle their claims.? For the bond insurers that are insolvent, this is the paradigm that will be followed as bad guarantees get settled.? And, this will probably be applied to Bluepoint, Wachovia’s subsidiary.? I agree with Calculated Risk, it is an interesting statement that Wachovia would not put fresh capital into it.? Just another sign that the equity is worth zero to Wachovia.
8) The bond insurers aren’t totally dead, though.? They are finding ways to exit debt they have guaranteed, and convert it to more liquid, valuable debts. Hey, every bit of risk shed is a plus, and they can report income in the short run from that.
9) The asset sales go on, as investment banks reconcile their SIVs and CDOs.? The tough part is taking the losses (surprise).? This is normal, because in illiquid markets where there is a lot of credit risks, there are few trades, and when things go bad, prices shift dramatically lower.
10) I have a bias against universal finance.? No company can manage all financial businesses well.? There are different risk control disciplines in different areas of finance, and when you put them together, risk control gets neglected in some businesses.? This was true at UBS, and now they are unwinding the mess.
A large-ish number of people have asked me to write this piece.? For those with access to RealMoney, I did an article called The Fundamentals of Market Tops.? For those without access, Barry Ritholtz put a large portion of it at his blog.? (I was honored .) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don?t know, liking the market from 2004-2006 was a pretty good idea in hindsight.
So, a number of people came to me and asked if I would write ?The Fundamentals of Market Bottoms.?? Believe me, I have wanted to do so, but some of my pieces at RealMoney were ?labor of love? pieces.? They took time to write, and my editor Gretchen would love them to death.? By the way, if I may say so publicly, the editors at RealMoney (particularly Gretchen) are some of their hidden treasures.? They really made my writing sing.? I like to think that I can write, but I am much better when I am edited.
Okay, before I start this piece, I have to deal with the issue of why equity market tops and bottoms are different.? Tops and bottoms are different primarily because of debt and options investors.? At market tops, typically credit spreads are tight, but they have been tight for several years, while seemingly cheap leverage builds up.? Option investors get greedy on calls near tops, and give up on or short puts.? Implied volatility is low and stays low.? There is a sense of invincibility for the equity market, and the bond and option markets reflect that.
Bottoms are more jagged, the way corporate bond spreads are near equity market bottoms.? They spike multiple times before the bottom arrives.? Investors similarly grab for puts multiple times before the bottom arrives.? Implied volatility is high and jumpy.
As a friend of mine once said, ?To make a stock go to zero, it has to have a significant slug of debt.?? That is what differentiates tops from bottoms.? At tops, no one cares about debt or balance sheets.? The only insolvencies that happen then are due to fraud.? But at bottoms, the only thing that investors care about is debt or balance sheets.? In many cases, the corporate debt behaves like equity, and the equity is as jumpy as an at-the-money warrant.
I equate bond spreads and option volatility because contingent claims theory views corporate bondholders as having sold a put option to the equityholders.? In other words, the bondholders receive a company when in default, but the equityholders hang onto it in good times.? I described this in greater measure in Changes in Corporate Bonds, Part 1, and Changes in Corporate Bonds, Part 2.
Though this piece is about bottoms, not tops, I am going to use an old CC post of mine on tops to illustrate a point.
Bubbles are primarily a financing phenomenon. Bubbles pop when financing proves insufficient to finance the assets in question. Or, as I said in another forum: a Ponzi scheme needs an ever-increasing flow of money to survive. The same is true for a market bubble. When the flow?s growth begins to slow, the bubble will wobble. When it stops, it will pop. When it goes negative, it is too late.
As I wrote in the column on market tops: Valuation is rarely a sufficient reason to be long or short a market. Absurdity is like infinity. Twice infinity is still infinity. Twice absurd is still absurd. Absurd valuations, whether high or low, can become even more absurd if the expectations of market participants become momentum-based. Momentum investors do not care about valuation; they buy what is going up, and sell what is going down.
I?m not pounding the table for anyone to short anything here, but I want to point out that the argument for a bubble does not rely on the amount of the price rise, but on the amount and nature of the financing involved. That financing is more extreme today on a balance sheet basis than at any point in modern times. The average maturity of that debt to repricing date is shorter than at any point in modern times.
That?s why I think the hot coastal markets are bubblettes. My position hasn?t changed since I wrote my original piece.
Position: none
I had a shorter way of saying it: Bubbles pop when cash flow is insufficient to finance them.? But what of market bottoms?? What is financing like at market bottoms?
The Investor Base Becomes Fundamentally-Driven
1) Now, by fundamentally-driven, I don?t mean that you are just going to read lots of articles telling how cheap certain companies are. There will be a lot of articles telling you to stay away from all stocks because of the negative macroeconomic environment, and, they will be shrill.
2) Fundamental investors are quiet, and valuation-oriented.? They start quietly buying shares when prices fall beneath their threshold levels, coming up to full positions at prices that they think are bargains for any environment.
3) But at the bottom, even long-term fundamental investors are questioning their sanity.? Investors with short time horizons have long since left the scene, and investor with intermediate time horizons are selling.? In one sense investors with short time horizons tend to predominate at tops, and investors with long time horizons dominate at bottoms.
4) The market pays a lot of attention to shorts, attributing to them powers far beyond the capital that they control.
5) Managers that ignored credit quality have gotten killed, or at least, their asset under management are much reduced.
6) At bottoms, you can take a lot of well financed companies private, and make a lot of money in the process, but no one will offer financing then.? M&A volumes are small.
7) Long-term fundamental investors who have the freedom to go to cash begin deploying cash into equities, at least, those few that haven?t morphed into permabears.
8 ) Value managers tend to outperform growth managers at bottoms, though in today?s context, where financials are doing so badly, I would expect growth managers to do better than value managers.
9) On CNBC, and other media outlets, you tend to hear from the ?adults? more often.? By adults, I mean those who say ?You should have seen this coming.? Our nation has been irresponsible, yada, yada, yada.?? When you get used to seeing the faces of David Tice and James Grant, we are likely near a bottom.? The ?chrome dome count? shows more older investors on the tube is another sign of a bottom.
10) Defined benefit plans are net buyers of stock, as they rebalance to their target weights for equities.
11) Value investors find no lack of promising ideas, only a lack of capital.
12) Well-capitalized investors that rarely borrow, do so to take advantage of bargains.? They also buy sectors that rarely attractive to them, but figure that if they buy and hold for ten years, they will end up with something better.
13) Neophyte investors leave the game, alleging the the stock market is rigged, and put their money in something that they understand that is presently hot ? e.g. money market funds, collectibles, gold, real estate ? they chase the next trend in search of easy money.
14) Short interest reaches high levels; interest in hedged strategies reaches manic levels.
Changes in Corporate Behavior
1) Primary IPOs don?t get done, and what few that get done are only the highest quality. Secondary IPOs get done to reflate damaged balance sheets, but the degree of dilution is poisonous to the stock prices.
2) Private equity holds onto their deals longer, because the IPO exit door is shut.? Raising new money is hard; returns are low.
3) There are more earnings disappointments, and guidance goes lower for the future.? The bottom is close when disappointments hit, and the stock barely reacts, as if the market were saying ?So what else is new??
4) Leverage reduces, and companies begin talking about how strong their balance sheets are.? Weaker companies talk about how they will make it, and that their banks are on board, committing credit, waiving covenants, etc.? The weakest die.? Default rates spike during a market bottom, and only when prescient investors note that the amount of companies with questionable credit has declined to an amount that no longer poses systemic risk, does the market as a whole start to rally.
5) Accounting tends to get cleaned up, and operating earnings become closer to net earnings.? As business ramps down, free cash flow begins to rise, and becomes a larger proportion of earnings.
6) Cash flow at stronger firms enables them to begin buying bargain assets of weaker and bankrupt firms.
7) Dividends stop getting cut on net, and begin to rise, and the same for buybacks.
8 ) High quality companies keep buying back stock, not aggresssively, but persistently.
Other Indicators
1) Implied volatility is high, as is actual volatility. Investors are pulling their hair, biting their tongues, and retreating from the market. The market gets scared easily, and it is not hard to make the market go up or down a lot.
2)The Fed adds liquidity to the system, and the response is sluggish at best.? By the time the bottom comes, the yield curve has a strong positive slope.
No Bottom Yet
There are some reasons for optimism in the present environment.? Shorts are feared.? Value investors are seeing more and more ideas that are intriguing.? Credit-sensitive names have been hurt.? The yield curve has a positive slope.? Short interest is pretty high.? But a bottom is not with us yet, for the following reasons:
Implied volatility is low.
Corporate defaults are not at crisis levels yet.
Housing prices still have further to fall.
Bear markets have duration, and this one has been pretty short so far.
Leverage hasn?t decreased much.? In particular, the investment banks need to de-lever, including the synthetic leverage in their swap books.
The Fed is not adding liquidity to the system.
I don?t sense true panic among investors yet.? Not enough neophytes have left the game.
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 kept me in the game in 2001-2002. I hope that I ? and you ? can achieve the same with them as we near the next bottom.
For the shorts, you have more time to play, but time is running out till we get back to more ordinary markets, where the shorts have it tough.? Exacerbating that will be all of the neophyte shorts that have piled on in this bear market.? This includes retail, but also institutional (130/30 strategies, market neutral hedge and mutual funds, credit hedge funds, and more).? There is a limit to how much shorting can go on before it becomes crowded, and technicals start dominating market fundamentals.? In most cases, (i.e. companies with moderately strong balance sheets) shorting has no impact on the ultimate outcome for the company ? it is just a side bet that will eventually wash out, following the fundamental prospects of the firm.
As for asset allocators, time to begin edging back into equities, but I would still be below target weight.
The current market environment is not as overvalued as it was a year ago, and there are some reasonably valued companies with seemingly clean accounting to buy at present.? That said, long investors must be willing to endure pain for a while longer, and take defensive measures in terms of the quality of companies that they buy, as well as the industries in question.? Long only investors must play defense here, and there will be a reward when the bottom comes.
I appreciated Steve Waldman’s article at his excellent blog Interfluidity, which was also posted at Naked Capitalism.? I have a slightly different take on the topic, which I expressed in the comments section of each blog:
Steve, I think we had two, maybe three things go on here. First, the “originate to sell” model failed because basic underwriting was not done well. The incentives against failure were not left with the originator, i.e., having to hold onto a large equity piece.
If the underwriting had been done well, the next problem would be weak financing structures on the part of the certificate buyers. Many were leveraged higher than prudent, even on “super seniors.”
Finally, the servicing models are often flawed. There has to be adequate pay for servicing and special servicing, or else loss mitigation efforts will be poor.
Risks were taken and avoided, but many of the seemingly avoided risks come back when the one guaranteeing the avoid risk cannot perform.
It is true that there was a lot of demand for AAA assets, but there was also a lot of demand for mezzanine and subordinated assets out of complex debt structures.? Within all investor classes, there was a hunger for excess yield, whether it was a little extra at the AAA level, or a lot extra for subordinated and equity levels.
The demand for AAA assets, whether senior or super-senior, was often driven by leveraged investors, seeking to profit from being able to arbitrage the AAA securities versus their funding rate.? Safe assets were turned into unsafe assets by the added leverage.
And in this sense, the rating agencies are culpable, because they let the concept of a AAA, which means capable of surviving a depression, drift to a lesser standard.? They trusted simple mathematical models, and did not spend enough time on the quality of underwriting.? Of course, that takes time, and profits for the rating agencies comes from cramming as many deals out the door as they can.? That is, if you don’t care about your franchise.
When I was a mortgage bond manager, I spent time on any deal, even at the AAA level by asking, “Who has skin in the game?”? If they were credible underwriters, I had greater comfort, but if the originator was selling and retaining little exposure to the outcome, I did not tend to buy.
Deal structure cannot make up for bad underwriting, usually.? Lousy assets lead to lousy returns for everyone in the capital structure.? I have owned AAA assets that have gone into default.? In every case, lousy underwriting of the original debts, not a bad economy, was the cause of the problem.
The entire period 2004-2007 was characterized by low spreads, as a hunger for yield depressed yields on newly issued corporate and structured debts.? Now we are facing the true value of those debt promises.
Of course after too much risk is taken, the regulators come along and say, “We must tame this!? No more excessive risk taking by investment banks because that leads to systemic risk.”? jck at Alea pokes at the recent efforts to do so, and if you look at the comments, I agree.
It is impossible to separate the desire for high returns from high risk-taking.? Having been a risk manager inside insurance companies, I read with some sympathy this article from The Economist.? Substitute actuary for risk manager, and marketer for trader, and the same situation plays out in insurance companies every day.
The only place that I have worked in that solved the problem bonused both marketers and actuaries on the same formula, offering slightly more reward from sales to marketers, and risk-adjusted profits to actuaries.? It got both sides on the same page, because they were compensated similarly.? I told the head of that division that he was fortunate to have business-minded actuaries.? He choked on his drink when I suggested that we were cheap for what he was getting.
My view is that investors did take too much risk 2004-2007.? They did it in many ways, by not underwriting properly, by levering up too much, by not servicing properly.? We are paying for that now.
Here’s a not-so-quick note on covered bonds.? What is a covered bond?? It is a form of secured lending, where a bank borrows money and offers a security as collateral.? That security remains on the bank’s books, but in a default the covered bondholder could claim the security in lieu of payment from the bank’s receiver.
It is not a passthrough, it is a bond.? The covered bond buyers do not receive the principal and interest from the security held by the bank, the bank receives it.? The covered bondholder (in absence of default) receives timely payment of interest at the stated rate, and principal at maturity.? Only in default does the value of the security for collateral matter.? If the collateral is insufficient to pay off principal and interest, the covered bondholders are general creditors for the difference.
Okay, so we’re talking about a type of secured lending, or secondary guarantee.? That exists in many places in different forms:
Credit Tenant Leases, which are secured first by the lease payments, and secondarily by the building.
Commercial and Residential Real estate loans are secured by property, and the ability of the debtor to service the loan.? Same for auto loans.
Utilities do a certain amount of first mortgage bonds where they pledge valuable plant and equipment, and receive attractive financing terms.
Enhanced Equipment Trust Certificates are how airlines and railroads do secured borrowing, pledging airplanes and rolling stock as collateral if they don’t pay.
Insurance companies in certain large states can set up guaranteed separate accounts.? If the insurance company’s General Account is insolvent, the separate account policyholders are secured by the assets of the separate account.? The separate account is tested quarterly for sufficiency of assets over liabilities.? If there isn’t enough of a positive margin, more securities must be added.? If those assets prove insufficient in an insolvency, they stand in line for the difference with the general account claimants.
Here is what collateral is eligible for the as the pool of assets securing the bonds (stuff from the Treasury document in italics):
Under the current SPV Structure, the issuer?s primary assets must be a mortgage bond purchased from a depository institution. The mortgage bond must be secured at the depository institution by a dynamic pool of residential mortgages.
Under the Direct Issuance Structure, the issuing institution must designate a Cover Pool of residential mortgages as the collateral for the Covered Bond, which remains on the balance sheet of the depository institution.
In both structures, the Cover Pool must be owned by the depository institution. Issuers of Covered Bonds must provide a first priority claim on the assets in the Cover Pool to bond holders, and the assets in the Cover Pool must not be encumbered by any other lien. The issuer must clearly identify the Cover Pool?s assets, liabilities, and security pledge on its books and records.
Further collateral requirements:
Performing mortgages on one-to-four family residential properties
Mortgages shall be underwritten at the fully-indexed rate
Mortgages shall be underwritten with documented income
Mortgages must comply with existing supervisory guidance governing the underwriting of residential mortgages, including the Interagency Guidance on Non-Traditional Mortgage Products, October 5, 2006, and the Interagency Statement on Subprime Mortgage Lending, July 10, 2007, and such additional guidance applicable at the time of loan origination
Substitution collateral may include cash and Treasury and agency securities as necessary to prudently manage the Cover Pool
Mortgages must be current when they are added to the pool and any mortgages that become more than 60-days past due must be replaced
Mortgages must be first lien only
Mortgages must have a maximum loan-to-value (?LTV?) of 80% at the time of inclusion in the Cover Pool
A single Metro Statistical Area cannot make up more than 20% of the Cover Pool
Negative amortization mortgages are not eligible for the Cover Pool
Bondholders must have a perfected security interest in these mortgage loans.
Other major requirements (not exhaustive — stuff copied from the report in italics):
Overcollateralization of 5% must be maintained.? It must be measured each month.? If the test fails, there is one month to get the overcollateralization over 5%, else the trustee can terminate the covered bond program and return proincipal and accrued interest to bondholders.
For the purposes of calculating the minimum required overcollateralization in the Covered Bond, only the 80% portion of the updated LTV will be credited. If a mortgage in the Cover Pool has a LTV of 80% or less, the full outstanding principal value of the mortgage will be credited.? If a mortgage has a LTV over 80%, only the 80% LTV portion of each loan will be credited.
Currency mismatches between the collateral and the currency that the bond pays must be hedged.? Interest rate mismatches may be hedged.
Monthly reporting with a 30 day delay
If more than 10% of the Cover Pool is substituted within any month or if 20% of the Cover Pool is substituted within any one quarter, the issuer must provide updated Cover Pool
information to investors.
The depository institution and the SPV (if applicable) must disclose information regarding its financial profile and other relevant information that an investor would find material.
The results of this Asset Coverage Test and the results of any reviews by the Asset Monitor must be made available to investors.? The issuer must designate an independent Asset Monitor to periodically determine compliance with the Asset Coverage Test of the issuer.
The issuer must designate an independent Trustee for the Covered Bonds. Among other responsibilities, this Trustee must represent the interest of investors and must enforce the investors? rights in the collateral in the event of an issuer?s insolvency.
Issuers must receive consent to issue Covered Bonds from their primary federal regulator. Upon an issuer?s request, their primary federal regulator will make a determination based on that agencies policies and procedures whether to give consent to the issuer to establish a Covered Bond program. Only well-capitalized institutions should issue Covered Bonds.? As part of their ongoing supervisory efforts, primary federal regulators monitor an issuer?s controls and risk management processes.
Covered Bonds may account for no more than four percent of an issuers? liabilities after issuance.
Issuers must enter into a deposit agreement, e.g., guaranteed investment contract, or other arrangement whereby the proceeds of Cover Pool assets are invested (any such arrangement, a ?Specified Investment?) at the time of issuance with or by one or more financially sound counterparties. Following a payment default by the issuer or repudiation by the FDIC as conservator or receiver, the Specified Investment should pay ongoing scheduled interest and principal payments so long as the Specified Investment provider receives proceeds of the Cover Pool assets at least equal to the par value of the Covered Bonds.? The purpose of the Specified Investment is to prevent an
acceleration of the Covered Bond due to the insolvency of the issuer.
Not more than 10% of the collateral may be composed of AAA-rated mortgage bonds.
My Stab at Analysis
The four percent limitation takes a lot of wind out of the sails of this for now.? The regulators are taking this slow.? They want to see how this works before they let it become a large part of the financing structure of the banks.
So long as this remains small, there shouldn’t be any large effects on the yields for unsecured bank bonds, both of which are structurally subordinated by the new covered bonds.? In other words, if some more assets are off limits in an insolvency, particularly more of the better-quality assets, that means that much less is there to recover.? Now, discount window borrowing and FHLB advances are secured already, so this just makes the issue of what is left in an insolvency to the unsecured lenders tougher.? That doesn’t affect depositors under the FDIC limits, but if you have deposits or CDs exceeding the limits, you might want to watch this issue.
Acceptable collateral is generally high quality, which means the bank has to pledge some of its better mortgages, and accept a 5% minimum haircut on the amount received back.? This should provide some support to the jumbo loan market; I didn’t see any size limits.? It looks like it would be impossible to issue subprime loans because of the 80% LTV, income verification, no neg am, first lien, underwriting must be done at the fully indexed rate.? Maybe some Alt-A could be done, but I’m not sure.? With the requirement that you have to replace collateral if a loan goes 60-days delinquent, I’m not sure a bank would want to put in collateral with a high probability of replacement.
For underwriting, an LTV of 80% or better is acceptable.? Other underwriting guidelines are left implicit to guidance given in the past on lending practices.? It’s possible that appraised values could be stretched to meet the 80% hurdle.? It’s happened before.
AAA-rated mortgage bonds are an interesting twist here as well.? I assume that it has to be AAA at every agency rating the bonds, first lien collateral, Prime or Jumbo collateral in order to be consistent with the intent of the document, but that is not explicitly defined.? Could a bank contribute a AAA home equity loan to the pool?? I doubt it, but…
Securitization is still getting done through Fannie and Freddie, but so long as the private mortgage securitization market is closed, this could be an attractive option for some banks to finance their mortgage loans.? When the securitization market comes back, covered bonds should reduce considerably as a financing source.? Overcollaterization for a securitization is less than the 5%+ that is necessary here, and it gets the loans off of your books, reducing capital requirements.? If I were a bank entering into a covered bond program, I would only borrow for the amount of time that I would expect the securitization market to be closed.? That could be years, but at some point, it will likely be cheaper to securitize, and the bank won’t want the mortgages trapped in the covered bond program then.
Beyond that, the bank would analyze whether it has better terms in securitized borrowing from the FHLB, or the newly non-stigmatized discount window of the Fed.? Even funding the loans through an ordinary deposit/MMMF/CD base would be most attractive under normal conditions, if the bank has the capital to support the loans.
Other collateral was proposed for use in covered bonds, but the regulators are taking it slow there as well.? They are starting with higher quality collateral; it might get expanded later.? The banks would probably like that.
Two final notes, and a tentative conclusion: this is a relatively complex solution for giving a new financing method to banks.? Only medium-to-large banks could be able to use it.? I’m not sure who a logical buyer of small transactions might be…. Hmm… maybe it could be a substitute for CD investors. 😉
Second, the inclusion of of a Specified Investment is interesting.? It further constrains what can be done with the proceeds of the bonds, which could be a big negative.? Are banks going to buy GICs from insurers?? BICs from other banks?? I don’t know.? Maybe I am misundstanding that part.
My conclusion, after all that, is that I don’t think this is going to be that big of a help to banks in the short run.? Why?
Small size of the program.
High overcollateralization.
Mostly (90%+) high quality mortgages can be pledged.
Capital requirements don’t change because the loans stay on the books.
Need for the Specified Investment.
Marginally increases the yields on unsecured debt.
But the benefit they get is a cheap-ish borrowing rate.? Would this get a AAA yield and rating?? Probably.? Is that enough to overcome the negatives?? Well, let’s watch and see, but I would expect it to have less impact than many expect.
With trends, I often try to answer the question, “Has the goat reached the end of the snake yet?”? (I got that phrase from a Canadian Investment Actuary with a quirky sense of humor.)? Another more common metaphor would be “What inning of the baseball game are we in?”? I’ll stick with the goat for now — but what I am considering is how far are we into the negative phase of the credit cycle, where:
bad debts develop
are realized
written off
new capital raised
capital calls fail at a few financial entities, leading to bankruptcies
contagion/ systemic risk worries multiply
moderate-to-weak capital structures come into question, perhaps a few fail…
increasingly, as failures happen, and marginal entities dilute the equity and raise capital, the number of zombie debts starts to decline
when the amount of zombie debts drop below a threshold, the credit markets realize that the rest is solvable, and the bull phase starts, usually with a roar.
Nine points?? Maybe I should get rid of the goat, and bring back the baseball analogy.? The nine points aren’t perfectly linear, though, and portfolio managers, both equity and debt, operate in a fog.? In 2002, when I was a corporate bond manager, I would sometimes take my head in my hands at the end of the day, and say to the more-experienced high yield manager who sat next to me, “This can’t go on much longer.”? When I would get that feeling, we were usually near a turning point.? The high yield manager would usually encourage me and tell me it was the nature of the market, and things change.
Part of the challenge is identifying the drivers of the credit bear market.? Is it the technology/CDO bubble (2000)?? LTCM (1998)?? Commercial real estate (1989)?? Here are two posts from the RealMoney CC:
When I think of the current market environment, I don’t think analogies to Autumn 1987, Autumn 1998, or 2000-2002 are proper yet.
What do I think are reasonable analogies? Mexico/bonds in 1994, Cash flow Collateralized Debt Obligations [CDOs] 1999-2001, Manufactured Housing Asset-backed securities [ABS] 2002-2004, and the GM/Ford downgrade to junk crisis in May 2005 when the correlation trade went wrong.
All of these were large enough in their own right to be minor crises, and they sent measures of systemic risk up for a while, but ultimately, they were self contained, because market players with strong balance sheets picked up the pieces from failed players, and earned a reasonable return off them after buying up the “toxic waste” at fire sale prices. What was a horrible idea buying at par ($100), can be an excellent idea buying at $30.
In general, my systemic risk proxies are falling. There is still systemic risk out there, a lot of it, but it will take a bigger crisis than Shanghai/subprime to unleash that. Just be careful; watch your balance sheets and your valuations — for long-term investors, that will reduce your losses in a crisis.
One more note: I believe gradualism is almost required in Fed tightening cycles in the present environment — a lot more lending, financing, and derivatives trading gears off of short rates like three-month LIBOR, which correlates tightly with fed funds. To move the rate rapidly invites dislocating the markets, which the FOMC has shown itself capable of in the past. For example:
2000 — Nasdaq
1997-98 — Asia/Russia/LTCM, though that was a small move for the Fed
1994 — Mortgages/Mexico
1989 — Banks/Commercial Real Estate
1987 — Stock Market
1984 — Continental Illinois
Early ’80s — LDC debt crisis
So it moves in baby steps, wondering if the next straw will break some camel’s back where lending has been going on terms that were too favorable. The odds of this 1/4% move creating such a nonlinear change is small, but not zero.
But on the bright side, the odds of a 50 basis point tightening at any point in the next year are even smaller. The markets can’t afford it.
Position: None
Add in the housing bubble, lousy credit quality in high yield issuance 2004-2008, mismarking of derivative books at investment banks, the troubles with CDOs, and growing problems in commercial real estate, and you have the main elements of the current financial crisis.? This crisis is broader than the previous crises.? Many players played it to the wire in a wide number of areas.
In this environment, the continuing fall of residential housing prices another 10-15% will lead to more bank failures, and failure of a few related institutions.? Commercial real estate has far to fall, and there is no telling what it might do to financial institutions.
So, we’re still in the middle innings.? The goat has only eaten one-third to one-half of the snake.? What this means to investors is to be careful of credit risk.? Avoid entities that need credit risk to improve for now.? And pray that we don’t get a negative self-reinforcing scenario where financial failures lead to more failures.
Be wary of credit risk particularly among financial stocks.
1) Going back to one of my themes, be wary of companies that sell their best assets to bail out their worst assets.? Tonight’s poster child is GM.? How to get cash?? Borrow against the remainder of GMAC, foreign subsidiaries (most promising part of the corporation), etc.? Not a promising strategy.? As I have said many times before GM common is an eventual zero.? Same for Ford.? All the errors in labor relations over the years, compounded with interest, are coming back to bite, hard.
2) So where does GM cut expense?? White collar retiree medical care.? This is rarely guaranteed, except to unions, so it is legal to cancel it.? A word to those whose corporations or state/municipal employers presently have retiree medical care.? It is worth your while to find out whether there are guarantees of coverage or not.? If there aren’t, I can assure you that it will be terminated in the next ten years.? If there are guarantees, then you need to see whether there are standards of care guaranteed, and whether the plan sponsor has the wherewithal to make good on his promises.
One more prediction: many states and municipalities will devise clever ways to escape guarantees over the next 20 years.? That will include Chapter 9 of the bankruptcy code.
3) Note to the SEC, not that the powers-that-be read me: if you’re going to require a contract to borrow shares in order to short for a bunch of financial companies, then require it for every company, now.? Shorts are not the problem.? Failure to properly locate and borrow shares is a problem.? Let there be a level playing field in shorting, and let the investment banks that are lending out more than they have suffer.? (Ironic, huh, ‘cuz they are the ones complaining…)
4) Note to the new management of AIG: please do the following: a) locate lines of business with low ROAs and significant borrowing for funding in order to achieve high ROEs.? b) Close down those lines.? Possible areas include GIC-MTN programs, and life insurance generally.? c) Take a page out of Greenberg’s early playbook, and exit lines, or sell off divisions where it is impossible to achieve superior ROEs.? (I can see American General re-emerging, with SunAmerica in tow!)
First, my personal bias. Almost every firm with a market cap greater than $100 billion should be broken up. I don’t care how clever the management team is, the diseconomies of scale become crushing in the megacaps.
Regarding GE in specific, it is likely a better buy here than it was in early 1999, when the stock first breached this price level. That said, it doesn’t own Genworth, the insurance company that it had to jettison in order to keep its undeserved AAA rating. Which company did better since the IPO of Genworth? Genworth did so much better that it is not funny. 87% total return (w/divs reinvested) for GNW vs. 28% for GE. A pity that GE IPO’ed it rather than spinning it off to shareholders…
But here’s a problem with breaking GE up. GE Capital, which still provides a lot of the profits could not be AAA as a standalone entity and have an acceptable ROE. It would be single-A rated, which would push up funding costs enough to cut into profit margins. (Note: GE capital could not be A-/A3 rated, or their commercial paper would no longer be A1/P1 which is a necessary condition for investment grade finance companies to be profitable.)
Would GE do as well without a captive finance arm (GE Capital)? It would take some adjustment, but I would think so. So, would I break up GE by selling off GE Capital? Yes, and I would give GE Capital enough excess capital to allow it to stay AAA, even if it means losing the AAA at the industrial company, and then let the new GE Capital management figure out what to do with all of the excess capital, and at what rating to operate.
Splitting up that way would force the industrial arm to become more efficient with its proportionately larger debt load, and would highlight the next round of breakups, which would have the industrial divisions go their own separate ways.
Position: none, and I have never understood the attraction to GE as a stock
6) One to think about: if US Bancorp is having a bad time of it, shouldn’t most large banks be having a worse time of it?? I spent a little time this evening reviewing the prices of junior debt securities of marginally investment grade banks (and a few mutual insurers, also).? The pressure on marginal financial institutions bearing credit risk is huge.
7) Speaking of junior debt securities, Moody’s gave the GSEs, and the US Government a shot across the bow when it downgraded the preferred stock ratings of Fannie and Freddie.? With the fall in the common and preferred stock prices, any possiblity of private capital raising fades.? The Administration and Congress should realize that whatever flexibility/help they grant the GSEs will be taken, and quickly.? Budget for the worst case scenario.
8) Then again, Ackman’s plan to restructure the GSEs, which is similar to mine (given in the last week), is reasonable.? Leverage is reduced and a market panic is avoided.
9) But even if neither plan is implemented, the dividends may be cut for the GSEs common stocks.? Shades of GM.? What is more significant, is if the GSEs feel they can’t issue preferred stock at acceptable yields, maybe they will omit those dividends as well.
10) Now, in the midst of expensive bailout talk, is there a cost imposed on the US?? Yes.? The dollar is weak, and default swaps on US government debt are rising in yield.? (Thought: how do swaps on US government debt pay off?? Hopefully not in dollars…? Also, what qualifies as an event of default?? Inflation doesn’t count, most likely, and yet that is one of the main ways for a government to try to escape debt.
11) Socialism!? Is the bailout socialism? Even for a libertarian like me, I can justify a bailout like Ackman’s, because it hurts those that tried to profit from the public/private oligopoly.? But no, I can’t justify what Paulson is trying to do, and maybe, just maybe, the market is sending him a message that half-measures won’t work.
12) More on preferred stocks.? They have been crushed.? This reinfirces why I rarely recommend preferred stocks, or junior debt securities: the payoff is low in success, and losses are high when things go wrong.
13) Let me get this straight.? You trusted Wall Street on an implicit guarantee?? You didn’t get a formal guarantee in writing?? Oh, my, it happens every decade… implied promises fail, and the cold, hard, printed text governs.? “Yes, that could technically be called, but don’t worry, they never do that.” “AAA insurance obligations never fail.”? “Portfolio insurance will protect you; you don’t have to buy puts.”? Never trust implicit promises of Wall Street, because in a real crisis, they go away.
14) Looking over some of my indicators, it looks like we are close to a bounce.? It feels a lot like January of 2008.? So, is it time to buy??? I’m not sure, but I am adding little by little to my stockholdings.? I’m probably going to up the equity percentage in some of my accounts where I have few options (old job Rabbi Trusts).
15) Not that I am likely to liquidate 401(k) assets, or anything like it.? That some are doing so is a sign of the stress that we are under.? Don’t do it, if you can avoid it.? Better, perhaps, to take in a boarder.? It increases cash flow on an underused asset, and optimally, increases community relations.
Ugh.? I’m still not home yet, but after my recent 48-hour news blackout, the news on Fannie and Freddie is pretty amazing.? Now, I would not be so certain that an interpretation of SFAS 140 would force Fannie or Freddie to raise capital — GAAP accounting often has little to do with regulatory capital rules.? Only if OFHEO decides to mimic the treatment in GAAP would it force capital-raising, absent any net worth covenants on their debt that might be poorly written.
All that said, the problems with Fannie and Freddie are not primarily accounting-driven, but are being driven by diminishing housing prices, which erodes their margin of safety on their lending and loan guarantees, and diminishes the value of the mortgage insurance that they rely on for some of their business.? Writedowns from these items are what hurt.? It is likely that Fannie and Freddie need to raise capital, but the great questions are how much is needed, and how much can the market stomach?
At times like this, I run through my pecking order of the “financing methods 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?
All of these financing methods carry a cost.? (And, as with most situations like this — if it were done, best it should be done quickly.? Delay usually means that cost of financing rises.)? Most of the cost is dilution to existing shareholders, whether common or preferred.? The debt guarantee, or investment by the government has costs for the US taxpayer, which I would rather not see.
Clearly, Fannie and Freddie have room to raise more capital, but the room is not unlimited.? As the Financial Guarantors found, when your stock price gets too low, the jig is up.? You can only raise so much capital relative to the size of your current market capitalization before the market chokes.? After all, most capital raising requires a discount to current price levels, and somehow the diluted value of the equity needs to represent a premium price where new capital gets put in.
In short: it’s tough to get new investors to pay for past losses.? Capitalize a new company?? Could be done, and has already happened with the Financial Guarantors, which has largely sealed the fate of the tarnished incumbents.? That said, why would the US government want a competitor to Fannie or Freddie, aside from GNMA?
As for the US Government, perhaps this all waits for a new President and Congress to act.? Personally, I think that any help extended to Fannie or Freddie should have strings attached.? Investments, or debt guarantees should allow the US government to profit if things turn around.? Other things to explore: only guaranteeing new liabilities, or, expanding the role of GNMA, which is a full-faith-and-credit of the US Government lender.
The one thing I don’t want to see is a bailout that benefits the shareholders of Fannie or Freddie.? They have long had private profits with many public subsidies for years.? Now it is time for the shareholders to bear the losses; let public money only step in to keep senior obligations whole, if it steps in at all.
(Note: these are my private opinions, and not those of my employer.)
We’re not quite to the endgame yet, but the jig is up for MBIA and Ambac, after the downgrades from Moody’s at the holding companies to Baa2 and A3 respectively.? Wait, why I am I mentioning the holding companies?? Isn’t it the operating subsidiaries that matter?
Well, yes, for sales and regulatory purposes, but the ratings at the holding companies matter for a different reason — notching.? But let me tell a story first.
Failure improves markets by introducing risk-based pricing.? In the late 80s and very early 90s, virtually all of the life insurance industry was rated AAA/Aaa, or A+ from A.M. Best.? Taking advantage of the good opinion that the raters had of the industry, many life insurance companies issued Guaranteed Investment Contracts [GICs] to institutions for their Defined Benefit and Defined Contribution pension plans.? The insurance companies levered up issued AAA liabilities, and invested the proceeds in lower rated bonds, commercial mortgages, limited partnerships, and other things yet more risky.? (These were the days prior to risk-based capital.)
After a few failures hit — Pacific Standard (who?), Executive Life, Mutual Benefit, Fidelity Mutual, Confederation, and the near miss on the Equitable (what a story — I was on AIG’s failed takeover attempt team), the rating agencies went into full scale defense mode, downgrading every company in sight.? It was everything a company could do to retain its ratings — and there were almost no ratings upgrades until 1996 or so.
The rating agencies are ratchets. (or, do I mean rackets? 😉 )? Downgrades come easily, upgrades come hard, and almost no corporate credit ever gets upgraded to AAA.? But, in this case, the downgrades have come for this industry in the way that I predicted earlier this year:
When the main rating agencies begin downgrading the lesser guarantors, the big guarantors are likely not far behind. Moody’s just downgraded XL Capital Assurance from Aaa to A3, and Security Capital Assurance From Aa3 to Baa3 (barely investment grade).
Psychologically, the major rating agencies, Moody’s and S&P, have been taking baby steps toward downgrading Ambac, MBIA and FGIC. But first they have to do the lesser guarantors that are in trouble. As I have pointed out before, the major rating agencies are co-dependent with the major guarantors, and that will only throw the guarantors over the edge if hurts them more to leave the guarantors at AAA. That will cost them future revenues to cut the ratings of the major guarantors, but it might save their larger franchises. (Fitch, on the other hand, has less to lose and can downgrade with impunity.)
Now, the effects on the broader insured bond market are probably overestimated. There will be new entrants to take the place of the legacy companies that may have to go into runoff. The holding companies for the major guarantors could die, but a rescue of the operating insurance companies in runoff mode is more likely. Those who own equity in the holding companies or debt claims to the holding companies will not be happy with the results, though.
Watch for downgrades of the major guarantors. Unless a lot of new capital gets pumped into their operating insurance companies, the downgrades are coming, maybe within a month.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
Position: none
Once your insurance operating subsidiary is downgraded below AAA/Aaa, there are many classes of business that cannot be written anymore.? Revenue dries up.? What’s worse, is that the rating agencies no longer have any practical reason to not downgrade further; the revenue model is broken for the rating agencies, and if there are highly rated new entrants, there is no reason to care about the company; the industry will survive, and the rating agencies will get fees.
Now, supposedly, New York doesn’t want to take the operating subsidiaries into conservation because it would trigger acceleration clauses in the CDS.? If those contracts were written at the operating companies, the insurance commissioner has the power to nullify any seniority those contracts possess — you can’t favor one insurance claimant over another.
Oh, notching — once a holding company is rated lower than Aa3/AA-, there is no way to get a subsidiary to have a Aaa/AAA rating.? The rating agencies will not allow it to happen.
So, I don’t see good things ahead for the guarantors.? Two final notes: Ambac tells Fitch to take a hike.? Fitch won’t do it.? Expect a downgrade soon.? Triad goes into runoff; my old colleague John must be smiling… he always thought they wrote the worst business.
In different economic eras, different things attract the attention of the media, investors, politicians, etc.? Today a leading attention grabber would be crude oil, and the energy complex.? It is a honeypot for conspiracy theorists and unscrupulous politicians (not quite an oxymoron).
2) Speculators — perhaps they need a new name, and a branding campaign.? Risk bearers, maybe.? I don’t know.? But discouraging speculation by raising margin requirements will not necessarily decrease the cost of crude — those who are short crude also face margin requirements.
Some look at the dollar change in prices and think that speculation must be high.? Bespoke does a good job in breaking it down into percentage terms, which indicates that the oil market has been more volatile more than half a dozen times in the past.
Do speculators include the ordinary shmoes like you and me who use ETFs?? I’ve used currency and stock and bond index ETFs, but not commodities so far.? Amazing how the trading interest on commodities has grown through ETFs — here’s another good chart from Bespoke.
As I have commented before, I think the run-up in the price of oil is fundamental, not manipulation.? Ignore the futures, and just look at spot prices — it is hard to affect where the real buyers and sellers trade in a global commodity.? If prices get too high, like the last move of OPEC in the 1979, where they overshot, and supply eventually overwhelmed their too high price.
3) We could be in overshoot mode now; it’s hard to tell.? As I have said before, sustained high prices are necessary to create the investment in alternative technologies that save energy and produce energy
more cheaply.? I don’t think that it will happen quickly though… in the early 80s, oil prices edged down, and then came down rapidly in the mid-80s.? It took a while for the new supply to be developed, and for conserving technologies to be created and deployed.
If you want a current example, think of the new big oil field found off the coast of Brazil.? It will be three years or so until we see new production there.? Another example is that it is hard to ramp up additional production from existing fields.? If you try to force more oil out more rapidly than is prudent, you can destroy the long-term viability of the oil fields.
4) But, there are dissenting voices, whether wishful ones like this one from a Japanese Vice Minister, or this article from Fortune which is more nuanced.? His arguments sound like mine, but on a faster timetable, with less consideration for future depletion.? This article from the Dallas Fed is similar; though it says that it will be difficult for oil to stay over $100/barrel in 2008 dollars, they have a ten-year horizon on that forecast.? Hey, even I think that oil will drop below $100/barrel within 10 years.
5) Now, there is demand destruction.? We are already seeing it in the UK.? We are not seeing it in China, yet.? Part of the difference has to do with China subsidizing gasoline, which blunts the market effect.
From this article, within a year gasoline demand is pretty inflexible with respect to price.? Beyond one year, people adjust their behavior.
And, it is worth noting that OPEC thinks demand in the US and globally is shrinking.? They are probably right, though the effect on price is problematic, because many oil producers can’t produce what the used to — Mexico, Venezuela, Indonesia…
6) Now, this article indicates that changes in demand for oil have been more significant than changes in supply.? Whether that will be true in the future remains to be seen, but as the rest of the world gets better off, they will demand more energy.? A wealthy life is energy-intensive.
7) Inventories are light compared to average, but I’m not sure that is as big of a factor as many indicate.? At the edges when inventory is close to capacity, or when it is close to running out, that has a big impact, but in the middle zone, the impact should be modest.
Because the Fed is stuck, it will let things drift for a while.
A certain amount of idealism is waning inside the Fed, with a creeping suspicion that they aren’t wizards, but only sorcerer’s apprentices.
9) It has been a long term theme of mine that the oil that is easiest to refine would get relatively more scarce.? This article from Naked Capitalism is another demonstration of that.? And, for those who want a stock pick, that favors Valero, which can refine the heavy and sour crudes.
10) A large part of the US current account deficit is the increase in the price of crude oil.? Eventually, the decline in the US Dollar will stimulate exports, but for a while, the J-curve effect remains in place, and the Dollar takes a beating.? That beating isn’t happening at this instant, but it has gotten hit over the past several years.? I’m not sure that this recent rise is the reversal, but there will come a time when the current account normalizes.? Hopefully other nations will liberalize trade; that would do it in its own.
Were I Dinallo, I would refuse to allow them to set up a new monoline. He has that authority for his own state. I might also take the existing companies into conservation. Then, let MBIA take their spare capital and try to set up a monoline in another state.The commissioners of the other states should refuse them as well, because they mismanaged an insurance company already. They are supposed to check these things when new insurance companies are formed.
Finally, I’m not sure how much good $1.1 billion will do them — If you look at the 2007 10K (page 161), and wipe out their investment in subsidiaries, and take the first quarter $2.4 Billion loss out… let them have the $1.1 Billion, their net worth is still negative.
Now, maybe the loss is at the subsidiaries, so their net worth at the holding company would be near zero. That would still cause them to violate the minimum net worth covenant on their bank debt, if they lost control of their subsidiaries.
The banks could force repayment, and if I were a leading bondholder (calling the major life insurers), I would have one of my lawyers make a courtesy call to MBIA’s lawyers, and suggest that any payment of bonuses could be viewed as fraudulent conveyance.
MBIA is in a bad enough spot, that I don’t see what good keeping the $1.1 billion does them in the long run. Thus, it has to be a short-term gambit.
Here’s the way I see the obligation to send capital to the subsidiaries:
No, they didn’t promise to shareholders or bondholders that they would do it. It was only their intent.
But, they probably did make promises to the rating agencies and NY State insurance Commisioner Dinallo.
If I were in the shoes of the ratings agencies, not downstreaming the capital is worth at least another two notches in terms of downgrades. Can the management be trusted? Probably not, which calls into question all the non-verifiable data that they have from MBIA.
If I were in the shoes of Dinallo, I would not allow MBIA to support just one of its insurance companies. I would ask for the $1.1 billion to be contributed so that risk based capital ratios at the subsidiaries would be close to even.
Now, things could be worse. They are worse for Security Capital Assurance, which could not wriggle off the hook of their obligations to Merrill Lynch. This has negative implications on similar efforts of other insurers to not pay as promised. Even XL Capital, which owns a large portion of SCA, and has guarantees on parts of SCA’s business that was not part of the Merrill suit, fell. It fell because:
the value of their SCA stake fell
The value of their guarantees to SCA rose; harder to repudiate.
General malaise across all financial guarantors.
As a final note, the leverage that MBIA and Ambac had with respect to their market shares has evaporated with the regulators and the rating agencies. Who knows, maybe even with their GAAP auditors… The need to support MBIA and Ambac was greater when the alternatives were fewer, but when you have Berky, Assured Guaranty (give ACE some credit for discipline here), Dexia/FSA, and maybe other new entrants, you can turn your back on everyone else as a regulator. You don’t care about the exotic coverages, and you’re glad they are going away — you just have to clean up the mess. As for the rating agencies, they have reconciled themselves to the idea that all but the municipal enhancement business is dead. So, say goodbye to MBIA and Ambac writing new business. That is over.
.) When I wrote the piece, some people who were friends complained, because they thought that I was too bullish.? I don?t know, liking the market from 2004-2006 was a pretty good idea in hindsight.
Here’s the way I see the obligation to send capital to the subsidiaries: