Tuesday, September 30, 2008 1 comments ++[ CLICK TO COMMENT ]++

Manulife CEO, Dominic D'Alessandro, Criticizes Mark-to-market Accounting

Most people probably never heard of him but Dominic D'Alessandro succesfully runs Manulife Financial, a Canadian insurance giant. He says that mark-to-market accounting is hurting insurers:

The same accounting rules that bank executives blame for exacerbating the financial crisis are going to make insurance more expensive for Canadians, says the chief executive officer of North America's biggest insurer.

...

The rules exaggerate the tendency toward greed and short-term thinking in the financial system, Mr. D'Alessandro said.

“One of the benefits that we've had here in Canada is we've been able to run our business constantly with the view as to what is the best economic decision, not what is the best accounting decision,” Mr. D'Alessandro said. “And we've been able to hold assets and invest our policy holders' money in a blend of assets which over the long term has delivered substantial value to them. Well, under the new accounting rules that have been foisted upon us, I'm not sure that's going to be possible going forward,” he said.

“The consequences are that, ultimately, consumers will pay a lot more for insurance, they'll be getting less value. Because if insurance companies, which have 30- and 40-year liabilities can't, because of the accounting model, invest in equities, or invest in long-term assets, or assets whose value goes up and down … It's just nuts,” Mr. D'Alessandro said.


I'm not a fan of fair-value accounting so I'm not going to re-hash my past arguments. All I'll say is that these financial firms benefitted from markt-to-market accounting on the way up, and that made it worse (possibly let them take on more debt and made them look better than they really were.)

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Thoughts On The Bailout and Related Issues

The bailout will likely pass in one form or another, now that presidential candidates John McCain and Barack Obama are asking for it to be supported. Some, such as Paul Krugman and John Hussman have argued that the Paulson plan misses the most important need: a need to provide additional capital to financial institutions. The linked article from John Hussman explains in clear layperson language why this bailout does not help the institutions in question, unless the government purposely overpays them. If the government does purposely overpay, it will raise ethical issues regarding who actually gets to make the decisions, who profits (or minimizes losses,) and so forth. A lot of left-leaning individuals, including me (I'm in Canada though,) have little faith the Bush administration. It already took the country on a totally ficticious war, fired attorneys that it did not like, formulated environmental policy in secret meetings influenced by industry, awarded very expensive military contracts with no, or in some cases questionable, bidding, and undertook massive tax cuts that are highly questionable. John Hussman speculates in an older article that the tax cuts, which largely went to the wealthy (most investors are wealthy), were recycled into the housing bubble, it might end up being the worst economic blunder by any government in several decades. It's one to thing to simply let a bubble blow bigger, but it's another to do so while significantly weakening the balance sheet of the nation. It's not clear who the Bush administration will "reward" by overpaying for assets (if they actually decide to overpay.)

Having said that, there is a reason Paulson and Bernanke are pursuing this even if it doesn't capitalize banks (unless they purposely overpay--Bernanke alluded to this with his 'hold-to-maturity' prices but no one has admitted to any solid numbers.) They, contrary to Krugman and others, feel that the lack of transparency and the lack of a market (many securites are supposedly not trading at all) are the big problems. They are betting a huge chunk of America's wealth that liquidity will solve the mess. People like me are skeptical but it remains to be seen.


It also seems that many so called free market supporters have started spouting nonsense. Going against what I said in my post yesteday, 24/7 Wall St is calling for the FedFunds rate to be cut to zero. A lot of these guys & gals are desperate and very short-term-oriented. I don't think I even need to go into it but to point out why that is a dumb idea, consider the side-effects. Why would any private investor provide short-term funding in such a scenario? One oft-ignored point in Japan is that the low interest rate has caused Japanese savings to flow to the rest of the world. Instead of it being invested in Japan, it ended up flowing elsewhere searching for higher yield. The low interest rates also led to their businesses being inefficent. If short-term rates are 0.5% and long-term rates are 3%, a business that can produce a 5% return is good enough (ever wonder why P/Es in Japan stayed high?).

Although I don't follow Austrian Economics--it's not science--one of the key reasons they don't want a central bank is because they would prefer if the interest rate is set by the market. If it was up to the bank, it can easily succumb to short-term desires of those on the Street and do something that mis-prices everything. Let's not forget that Alan Greenspan was considered a 'maestro' and was heaped praise all throughout his tenure, even though holding rates low kept blowing a bigger bubble. It's doubtful that the market would have kept rates that low for so long. I'm not against central banks but just presenting this view so that we can avoid one of the potential problems cited by the Austrian Economists.

24/7 Wall St is having a bad day today with another suggestion of bailing out hedge funds because their collapse will hurt the banks. Again, it's a ridiculous argument so I'm not sure it's worth saying much. Everyone seems to have forgotten that losses when things sour should accrue to the risk-taker. The biggest problem out there is leverage. Not just in banks but also in hedge funds. If hedge funds are bailed out, they will keep doing what they have always done. In fact, I would argue that some funds out there won't survive without leverage. That is, the only reason some of these funds seem to post good returns--returns worth paying 2% MER + 10% of profits--is because of leverage. Even a dumb guy like me can take a below-market 8% return and turn it into way-above-market 16% return with 2x leverage.

All of this is quite surreal for me. I consider myself left-leaning so I'm ok with select government intervention, bailouts, subsidies, and so forth. But now we are seeing all these self-proclaimed free-market supporters, ranging from publications like 24/7 Wall St to WSJ to private ones, calling for huge bailouts. Ironically, these were precisely the ones that were bashing government and calling for de-regulation all this time. It seems that the self-proclaimed capitalists have become communists.

I'm not against government intervention but there needs to be a high probability of real benefit... I just hope the Canadian government doesn't start doing something stupid soon.

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Monday, September 29, 2008 1 comments ++[ CLICK TO COMMENT ]++

Cutting Rates Won't Help

UPDATE: Added a chart from The Economist showing the deposit insurance in various countries.

Some are calling for the FedRes to cut rates but, on top of potentially causing inflation problems down the road, it won't have much impact. Look at the yield curve in the US (chart courtesy Bloomberg):



If banks can't make money off this, they never will. A rate cut will simply cause the likely bubble in US Treasuries to hit even more of an extreme, while credit costs in other areas of the economy (mortgages, credit cards, corporate bonds, etc) remain the same.

While this bailout works its way through the government--they only need 20 votes and it should be doable--other solutions need to be considered.

I don't generally agree with Jim Cramer but one of his latest arguments calling for the insured limits at banks to be increased from $100,000 to, say, $1 million is a small step that can help the banks. The threat right now is a run on these banks and a higher limit (assuming it is backed by greater financial resources at FDIC) will prevent this scenario. Some say regional banks are the next ones to face problems and these guys really need the deposit base. Bank runs are a real possibility for these regional banks since they are not as big and don't have the marquee brand name.

The following chart from The Economist shows the deposit insurance in various countries:



USA is near the lead but given that it is the wealthiest country on earth (ignoring little ones such a island states,) one would expect a higher limit. I'm not saying the deposit insurance really solves any problems; rather, it avoids the problem of a run on the bank.

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Big Sell Off On Failed US Government Bailout...Could Be A Short-Term Bottom

Needless to say, big sell-off in the market due to the US government voting down the bailout. Note that the sell-off is with short-selling bans of many of the key stocks on the exchanges. The market could have plunged even further if short-selling was allowed. This could be a short-term bottom but don't rely much on my short-term calls...

(source: The Wall Street Journal, wsj.com; powered by SmartMoney.com)


Although it was a surprise to me and the market, I guess it was always possible that the US government bailout would be voted down. If people like me, who has almost all his wealth invested (my net worth is very low though,) were skeptical, it's even harder to get the politicians on board. I am actually OK with the bill that was finalized. It's nowhere near perfect but it did address my two concerns: (i) immense power for the Treasury, and (ii) penalties for mistakes. The New York Times reports the final vote as the following:

The vote against the measure was 228 to 205, with 133 Republicans joining 95 Democrats in opposition. The bill was backed by 140 Democrats and 65 Republicans.


I am actually surprised that the Republicans voted down this bill. I would have thought that any failure would be due to Democrats but George Bush is a lame-duck president and does not have much influence anymore--even within his party. This bill will pass, in one form or another. Both presidential candidates support the bill, and it shifts a chunk of the spending to the next administration so it isn't as monumental as it seems. It'll get modified and re-submitted but it will only be a partial solution to the current financial crisis. Anyone expecting the bailout to save the markets are going to be dissapointed.

Having said all that, we may be near a short-term bottom...

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Principal-protected Noteholders Get The Shaft

I have never invested in them but I always assumed they were low risk. I am referring to principal-protected notes. These consist of a diverse set of securities, often producing returns tied to some index. For example, a security that pays you returns based on the performance of the European Dow Jones STOXX Index. Some of these notes promise that the principal will be returned at maturity. I never realized that these were an unsecured claim on the issuer. Bloomberg points out how many investors of notes issued by Lehman Brothers have suffered:

A brochure pitching $1.84 million of notes sold by Lehman Brothers Holdings Inc. in August, a month before the firm filed for bankruptcy, promised ``100 percent principal protection.''

Buyers had ``uncapped appreciation potential'' pegged to gains in the Standard & Poor's 500 Index, the brochure said. In the worst case, they would get back their $1,000-per-note investment in three years. Only the last in a list of 15 risk factors mentioned the biggest danger: ``An investment in the notes will be subject to the credit risk of Lehman Brothers.''

Lehman's Sept. 15 bankruptcy leaves holders of the notes waiting in line with other unsecured creditors for what's left of their money. The collapse has rattled Wall Street's $114 billion structured-notes business, which Lehman, Merrill Lynch & Co., Morgan Stanley and Goldman Sachs Group Inc., all based in New York, used to raise cheaper funding as the credit crisis drove bond yields higher.


Issues like this are what causes retail investor confidence to plummet. It's really a bad situation for the investors in these notes, many of whom were retail investors.

Exchange-traded notes (ETN) are also another instrument where the credit quality of the issuer matters. In contrast, an exchange traded fund (ETF) does not depend on the issuer. ETNs generally track specialized indices or non-equity indexes. An example of an ETN is the iPath Dow Jones-AIG Agriculture Total Return Sub-Index (ticker: JJA).

So anyone investing in these products should be considerate of the credit risk inherent in them.

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Sunday, September 28, 2008 2 comments ++[ CLICK TO COMMENT ]++

The Big Risk Is That Almost Every Single Asset May Decline

One of the things that has worried me over the years is the possibility of nearly all assets declining. I first came across this concern from Marc Faber, who has often pointed out that the bull market in the last 5 years has been very unique. Almost everything--US stocks, emerging market stocks, emerging market bonds, commodities, gold, junk bonds, real estate, art, collectibles--have gone up since the early 2000's. It is very unusual. Historically, if commodities prices went up, broad-market stocks went down. I don't think too many would have imagined that the S&P 500 would hit an all-time high while oil prices go up 5x from $20 to $100. The huge decline in the US$ is part of the reason but that alone cannot explain any of this.

Although the situation may not turn out as dire, the possibility exists. I feel like some of what Marc Faber said in 2007 describes the current situation quite well. Let me quote his words from a Financial Sense Newshour interview with Jim Puplava from January 2007 (bolding of text is by me):

MARC: I think that all asset prices have gone up dramatically since, you know, depending 2001, 2002, 2003, but basically we’re up everywhere. If I look around the world there are very few assets that are not expensive. And the big surprise for this year could be that liquidity tightens even if the central bank tries, say, to keep monetary policy easy, because if you look at the Middle East, suddenly all of the markets are down between 50 and 60%. There’s still plenty of liquidity. But the issue there is that liquidity growth slowed down – it didn’t accelerate anymore. And if I look at international reserves in the world they’re still growing at 18% per annum, but they’re no longer growing at an accelerating rate. So it could be that at some point in 2007 liquidity tightens.

I’d also like to make the point that when markets go up they create liquidity because [when] an asset goes from, say, 100 to 200, it increases the borrowing power of the owner of these assets. And when asset prices go down (and we’ve had an appetizer of that in April, May 2006 when suddenly the markets went down – suddenly liquidity dwindled)…And I think the big test for liquidity will come once there is a correction. And I think we’re by historical standards in one of the longest bull markets, which began in October 2002; we’re in a bull market that by historical standards is about average length in terms of magnitude; and since July 13th 2006 when this latest leg in the bull market started we haven’t even had a 2% correction. Now, I lived through the 70s. In the 70s the markets moved sideways but every year the Dow went up and down by about 25%. And here we are and we haven’t had a 2% correction since last July. Something big is going to happen one of these days. And I would not rule out that markets may continue to go up, but as a buyer the risk now is actually quite high compared to the potential reward. It’s as John Hussman recently wrote that there are so few bears (from converting these very few bears into bulls) that the market will not get a lot of ammunition on the upside. But if suddenly so many bulls turn cautious or negative then obviously the downside can be quite substantial because people will liquidate their positions. [8:56]


Marc Faber is into technical analysis--I am not--so I don't pay much attention to the latter part of the quote. It's also very difficult to make money off any of this because it's hard to predict the timing. However, one can avoid getting themselves stranded in a storm by paying attention. On top of all this being largely prescient, one of the key things he points out is how liquidity is amplified when asset prices rise. We can see this in action. In reverse!

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Added to Watch List: Sears Roebuck Acceptance Corp 7.4% Notes Due In 2043

This is just an idea... somewhat wild and risky, as usual. I'm not sure if I will do anything because this one trades on the over-the-counter Grey Market (extremely thin volume--not suitable for large investors or funds) and I'm not sure if I have access to it from my discount broker. Ideally I want to hold it in my tax-sheltered account but I don't believe that broker supports the Grey Market so I'm down to my normal one (not sure if that supports it at a reasonal commission.)

I'm thinking of investing in a super-long-term junk bond. The bond in question is Sears Roebuck Acceptance Corporation 7.4% note due in 2043. You can find the IPO prospectus here (For those not familiar, QuantumOnline is the best free site for exchanged-traded debt/preferred instruments.) Here are some details of this issue:

Security: Sears Roebuck Acceptance Corp., 7.40% Notes due 2/1/2043
Ticker: SBCKO (over the counter Grey Market)
Issuer: Sears Roebuck Acceptance Corporation (subsidiary of Sears Roebuck)
Current Price: $9 (36% of par value)
Current yield: 20.5% (highly illiquid; not sure if one can get it at that yield)
Rating: Ba1/BB+ in 2005 (may not be up-to-date)


This was a baby bond--$25 par value exchange-traded bonds--that used to trade on NYSE but was delisted after Sears called in the bond for redemption. But only a portion of it was tendered and what you see is the remaining. This means that it is hard to get information and I assume interest is still being paid (but since I never dealt or followed a situation like this, I'm not too sure.) The company, Sears Roebuck Acceptance Corp, also does not report to the SEC anymore so nothing has been filed with the SEC since it was delisted from NYSE.

If I understand the corporate structure correctly (haven't read through it fully,) Sears Roebuck Acceptance Corporation (SRAC) is a subsidiary of Sears Roebuck, which is a subsidiary of Sears Holdings. SRAC is essentially used to raise capital for Sears. SRAC holds short-term notes and similar items issued by Sears. This means that the claims against Sears wouldn't be as strong as if you owned bonds directly issued by Sears. I can't tell what SRAC actually owns right now.

The big risk with bonds is inflation. Unlike stocks, where earnings/dividends increase over time, bonds pay a fixed coupon. Usually stocks, even if they started off with a dividend yield of 3%, will beat bonds 15 to 20 years down the road. In this case, I feel that I'm adequately compensated for the inflation due to the bond trading around a third of par. Even if you assume inflation is 4% for the next 30 years, you have around 200% upside simply from the par value (this assumes that the bond will not default and the company isn't bankrupt and unable to return the principal.)

The real risk here is the possibility of bankruptcy. The market doesn't have much faith in the future of Sears, let alone over the next 30 years. Rating agencies, for what they are worth, are also predicting increased default rates for junk bonds:

Non-financial junk bond defaults may top 23 percent by 2010, the highest level since 1981, as the U.S. financial crisis deepens, Standard & Poor's said on Thursday.

That suggests 353 non-financial firms could default between 2008 and 2010, as that three-year cumulative rate rises, with the most defaults coming after the first half of 2009, S&P said.

...

Consumer products, media and entertainment, and the retail and restaurant industries will be among the worst hit, similar to defaults seen in 1990 and 1991, S&P said in a report.


Note that S&P highlights retail as one of the areas that will see increased defaults. Sears is rated way below investment grade and some bears claim it will go bankrupt soon. I have somewhat followed Sears from the equity side and I don't see it defaulting on its bonds any time soon. It's leverage is very low--one of the lowest in the retail industry--and it's hard to see how it can fail to pay bondholders. If the economic environment deteriorates significantly--worse than the 1990 recession and on par with the 1930's--then anything is possible but I don't see it as being likely. Even then, although I can't tell what is backing these bonds (supposedly some short-term liabilities of Sears but it's not clear,) I am somewhat confident that the liquidation will yield sufficient money to pay off the bondholders (at least at current prices of around 1/3 of par.)

So, in terms of default, I don't think the risk is the present cycle (say next 5 years.) Rather, the risk is whether it will default 15 to 20 years down the road. That is a big question mark, but, again, I suspect that there are enough assets to pay off bondholders. To sum up, I don't think the default of default/bankruptcy is high.

Another problem is the conflict between bondholders and shareholders. Even if Sears shares do well, the bond could a disastrous investment several decades from now. For instance, it is possible that Eddie Lampert, the majority owner, will extract much of the value from the company and reward shareholders, while the bondholders are supported by left-overs that may not survive the next few decades. Shareholder and bondholder interests can diverge at critical times, and this is a risk you have in any debt investment.

Anyway, I haven't done much this year (maybe Ambac made me lose my confidence; or maybe the volatile markets make me want to wait) but this is something that is close to a price I like. There are many others on my watchlist that aren't at prices I am willing to buy at.

(There is also another similar one with ticker SBCKP that one may want to consider. Also, I should note that I have also been evaluating the equity for a while now so may make an investment in the shares instead.)

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Financial Equityholders Started Sufferring First...Bondholders Likely To Be Next

There are some dark clouds gathering in the debt markets. The clouds have been building for a while now but the final fate may be near. The storms will be threatening...

So far, the losers in the credit crisis that was started by the subprime virus have been shareholders. Many have suffered monumental losses, including yours truly, not to mention such illustrious ones as Hank Greenberg of AIG, who lost almost his entire net-worth of $3 billion. Not complaining here; it's the nature of markets and there is a reason we invest in equity.

Bondholders of financials, in contrast, have sailed smoothly, albeit in rocky seas, for the most part. However, that is in the process of changing and it will have massive ramifications for the investing world. Credit markets--the bond prices, as well as CDS on those bonds--have been signalling losses but it never really happened on a large scale until recently. The collapse of Lehman Brothers was perhaps the first sign that bondholders are at real risk of loss (do note that companies go bankrupt literally every week, with bondholders taking huge losses, but I'm talking about large scale losses.) However, the real big historic loss would be from Washington Mutual. It looks like bondholders of Washington Mutual will end up losing everything.

If bonds of financial companies start defaulting, it will have two big effects. It will weaken confidence in an already-doubtful marketplace. This essentially means cost of debt financing will increase. It's also not clear who owns these bonds. I think foreign central banks are primarily invested in low-risk bonds of the US government or its agencies (eg. Fannie Mae, Freddie Mac, Farmer Mac, etc.) So these bonds are likely owned by retail investors, mutual funds, hedge funds, or corporations. Some of these entities may start posting big losses on bonds of financial firms (default rates are also projected to increase for other industries but I don't see similar damage as with financials.)

The other result is that there is likely to be huge CDS payments for the defaulted bonds. Since financial companies often had high ratings, it would not surprise me if the CDS contracts were underpriced (think of what the monoline bond insurers did with mortgage bonds and replace it with corporate bonds of banks.) This could rock the CDS marketplace. There was some concern after Lehman Brothers went down but I suspect very few would have considered an investment bank to be as safe as a commercial bank.

To me, it is almost inevitable that bondholders would take losses. So far, the government has bailed out some key players (Bear Stearns, AIG, Fannie and Freddie) but if more banks fail--some expect a great number of regional bank failures--then the government may not be able to bail out all the bondholders. Some commentators such as John Hussman argue that bondholders should not be bailed out (read the portion in the middle). It is not only prudent but it seems inevitable in my eyes. The core problem is not simply that there are real estate losses; rather, most of the firms in question have high leverage. Once the equity is wiped out, bondholders will have to pay the price--unless the government bails them out.

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Saturday, September 27, 2008 2 comments ++[ CLICK TO COMMENT ]++

Articles For The Last Weekend Of September

By some accounts this has been the worst September in economics and finance in American history. Who knows how correct that description is but here are some articles I found interesting for the last weekend of September:



  • Jim Grant on the bailout: I ran across the linked Jim Grant article from a Controlled Greed post. The key concern he raises is the future of the US$. I personally don't think it is as dire as it seems (but it depends on the details.) I think the US$ will only start to face problems if the US governemnt prints money rather than borrowing it. Forigners might demand slightly higher rates but it isn't anything big. Right now, I'm bullish on the US$ due to my belief that there will be capital flight into it (away from risky assets and markets, such as emerging markets.)
  • Excessive leverage is the problem: Fortune has a basic article talking about the excessive debt that American financial firms took on in the last decade. A chart that is referenced shows American loan to deposit ratio at 3.5, whereas most of the key countries in the world are closer to 1.
  • How a 377-employee division brought down a 116,000-employee company we know as AIG: It's amazing, really. Superb job from the New York Times on this story. Anyone with interest in AIG should check it out. I never would have thought that such a large insurer would collapse. To think that a formerly AAA-rated insurer had to be nationalized is hard to believe.A lot of it is due to management incompetence. You simply cannot justify how such a large firm with valuable assets would end up like that. Some people think Maurice Greenberg, the prior CEO, would have run things better but I am not so sure. Credit derivatives were booming under his watch a few few years ago...Oh, a trivia bit I learned this week, not that it has any positive impact on my life at all: Guess where AIG started off? Believe it or not, China! I always thought that AIG was started in America but it actually saw its beginning in China (started by an American.)
  • American consumer likely tapped out: I don't know who coined it but there is a famous saying that one should not count out the American consumer. A lot of people who bet against the American economy a few years ago turned out to be completely wrong. But I have a feeling that this may be it. I think you are finally going to see contraction in consumer spending. This has happened to a minor degree in the last year but you are going to see it continue. This is going to send out ripples across the investing world. I suspect there are going to be serious issues in some of the emerging markets soon. As Marc Faber insightfully pointed out last week, America produces very little of anything anymore (it's mostly a consumer) so an economic slowdown will have less of an impact than on production-oriented countries. I would be very wary of wandering into China, Vietnam, Phillipines, or other similar nations right now. I think one should start researching now but I'm not sure if investing now is the best thing.
  • The New Yorker's James Surowiecki on the current crisis: He's a great financial writer for non-financial readers.
  • Bailout, the musical: You know the financial crisis is getting serious when artistic/literary publications like The New Yorker start parodying it in a musical. Really good musical written by Ben Greenman... LOL fun stuff :)


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Friday, September 26, 2008 3 comments ++[ CLICK TO COMMENT ]++

Michael Callen (Ambac CEO) Interview

Bloomberg has an interview with the CEO of Ambac, Michael Callen. As usual with these Bloomberg links, click on the link on the top-right (for some reason I can't link directly to the URL--it gets cut off in my post.)

Just to quickly recap, he clearly isn't happy with the rating agencies. Ambac will be facing a tough situation if it gets downgraded. The insurance regulators, unlike many other regulators, are quite knowledgeable and are friendly to the bond insurers. They will let Ambac Assurance transfer some money to the investment business but I just don't want to be bugging them too much. Whenever Ambac runs up to the regulator, it sort of burns some good faith.

Callen seems to pin a lot of hope on the government bailout; whereas I think it will only tangentially help the bond insurers. The problem, on top of the moral issues I have ranted about, is the fact that price discovery is still going to be elusive. Everyone seems to think that we will get liquidity and prices will get closer to true intrinsic value but I just don't see it. I still think it will all come down to actual defaults/losses on the mortgages. No one talks about it but the only good thing right now is that the US economy is actually doing ok. The commodity price declines--it can drop even more--should provide a small boost.

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Thursday, September 25, 2008 3 comments ++[ CLICK TO COMMENT ]++

Washington Mutal Fails... Biggest Bank Failure in American History

The severity of any crisis can be judged by the size of the largest failure. Well, we just had the biggest failure in American history when Seattle-based Washington Mutual was taken over by the government:

Washington Mutual, the giant lender that came to symbolize the excesses of the mortgage boom, was seized by federal regulators on Thursday night in the largest bank failure in American history.

Regulators simultaneously brokered an emergency sale of virtually all of Washington Mutual to JPMorgan Chase. The remainder of WaMu, the nation’s largest savings and loan, will be operated by the government. Shareholders and some bondholders will be wiped out. WaMu deposits are guaranteed by the Federal Deposit Insurance Corporation up to the $100,000 limit for each account. WaMu customers are unlikely to be affected.


Washington Mutual was the 6th largest bank in America, and had $310 billion in assets. It operates primarily in the west coast and hence was heavily exposed to the housing bubble areas of California.

Just to show that I'm not the only dumb investor around ;) private equity group TPG invested $7 billion early this year, only to see it vaporize completely. WaMu as it is sometimes called was also one of contarian investor David Dreman's favourite investments.

I hate to bring this up but JP Morgan Chase is not only becoming a too-large-to-fail bank, but also a too-big-to-be-rescued-by-the-US-government bank. JP Morgan Chase has the largest derivatives book of any bank in the world, and if it something happens, America is going to have to seek help from outside--an unthinkable scenario that will significantly weaken its political power. I am not a fan of these banks the size of a star system.

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Why Bailouts Are Contrary To Free Markets

Bailing out failed institutions or those that would fail anyway is generally considered to be anti-free-market. Since all the true free market proponents have been separated from the fake ones--the fakers being ones that subscribe to what I call the Wall Street Journal form of capitalism--you don't hear too many arguments illustrating why they are against the free market.

Well, the problem with free bailouts is that it rewards the failed institutions, their workers, their shareholders, and their bondholders. Want to see it in real time?

Consider the argument from John Allison of BB&T Corporation, a bank:

U.S. Treasury Secretary Henry Paulson's proposed $700 billion bank rescue aims to help ``poorly run'' companies and the primary beneficiaries would be Goldman Sachs Group Inc. and Morgan Stanley, said BB&T Corp. Chief Executive Officer John Allison in a critique of the plan.

Treasury ``is totally dominated by Wall Street investment bankers'' and ``cannot be relied on to objectively assess'' the impact of government policy on the financial industry, Allison wrote in a Sept. 23 letter to Congress.


Here we have BB&T bank, which seems to have cleared completely of subprime mortgages and seems to be managed successfully. Yet, such a bank will derive zero benefit from the bailout and would actually face competition from the failed risk-takers on Wall Street and elsewhere if the bailout makes them whole. If you wanted hundread banks in your country would you not want them to be more like BB&T?

Is this not what crony capitalism is? The fake free-market proponents--the WSJ free marketers--have a habit of criticizing crony capitalism in poor, developing, countries and never seem to understand how it manifests itself. I am not against the bailout but there should be a penalty--a contingent equity stake--if purchased mortgages turn out to be toxic. Otherwise, this is no free market at all. We are going to end up with a hundread banks that will eat the wealth of the country. I would rather have a thousand executives like John Allison--all else being equal--than almost anyone that is running a financial firm that will profit from this bailout.

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Marc Faber on CNBC and Bloomberg

UPDATE: Fixed Bloomberg video link

UPDATE II: I found some insightful nuggets in the Marc Faber interview with Bloomberg. Some may not like an extremist like him but he always presents a different perspective. While you are at it, if you feel like it, you might also want to check out this Jim Rogers rant. Nothing insightful except for his comment that he has covered all his shorts of homebuilders, Fannie, and financials, except the investment bank shorts. Since the only two investment banks left are Morgan Stanley and Goldman Sachs, I interpret this to mean that he thinks these two still have some ways to drop. I can see this happening because these two need to de-leverage and any such move will result in share price declines (instead of selling assets, you can try to take on more equity as Goldman Sachs recently did, but that dilutes shareholders.)

Well, Marc Faber is super bearish right now but that's nothing new from Dr. Doom. Do note that he is sometimes wrong and macro calls are hard to nail. Also note that he is a bear and hence is generally negative on most things. There are two interviews he has given recently:

Bloomberg (click on link on top-right)
CNBC (thanks to The Big Picture for original mention)



On the CNBC interview, where he likens the Federal Reserve to a drug dealer giving out free money, he sees potential for a big slump. For what it's worth, I do not share the same negative views of the FedRes. It's up to the individual or the business to decide whether to use cheap money and leverage themselves. Blaming the FedRes shifts responsibility from the individual to some faceless government entity.

"Next year, if the economy in the U.S. is as weak as I think it would be, the trade and the current account deficit will continue to contract," Faber said. "When global liquidity contracts, it's not a good time for financial assets."


This is probably the most important macro theme that will unfold over the next five years. Basically the opposite of the last 5 years, where the US current account deficit was expanding and the US$ declining, would likely occur. This is good for the fiscal situation in America but it's bad for investments. US savings rate will go up and the US$ should go up, if this scenario plays out. This is a tricky situation to invest. The US$ would appreciate but financial assets like stocks and bonds may not (financial asset performance depends on how Americans recycle their increased savings.) Commodities, which are generally inversely related to the US$, will likely get hit as well. This likely means that foreigners will find US$-denominated assets more attractive (this is the opposite of the last few years, where Americans found foreign assets more attractive due to the declining US$.)


In the Bloomberg interview, he says he is bearish on China and India as well. I share his views on emerging markets. I don't think I am as bearish on the US economy as he is. One of the reasons is because American corporate balance sheets (excluding financial firms) are solid so companies aren't skating on thin ice like they typically do going into slowdowns.

``I don't believe this is going to be solved in six months to a year,'' Faber said.

Faber also forecast the Standard & Poor's 500 Index will rally to as high as 1,350 points following the approval of the bailout plan because stocks are ``oversold.'' That level is about 14 percent higher than the gauge's close yesterday.

Still, ``I'm not playing that rally,'' he said. ``I'd rather think that stocks are not particularly cheap. We don't have a valuation bubble. We have an earnings bubble. In 2009, earnings will disappoint.''


His earnings comment is very important. If earnings are actually at a peak then valuations are not as cheap as they seem.

``Economies like China that grow very rapidly can have significant adjustments,'' Faber said. ``I'm not negative for the long term. It's just that from a cyclical point of view the Chinese economy could turn out to be weaker than what analysts are telling you.''

India is also ``not problem-free,'' Faber said. He forecasts the Bombay Stock Exchange's Sensitive Index, or Sensex, will fall below 10,000. The Sensex is down 33 percent this year.

``I think new all-time highs in markets are most unlikely for the time being,'' Faber said. ``So I'm not particularly interested to play the market at the present time.''


I think the consensus is coming around to a bearish view. I feel that the consensus is still too bullish on China. Even though everyone admits that the Shanghai and Hong Kong stock markets are down significantly, many still detach their economy from the performance of stocks and are assuming that the economy will do well. I think many are going to be shocked to see a material slowdown. If I'm not mistaken, around 8% growth is a recession in those countries--you need around that much to create jobs for new entrants--and I can see China getting close to that. China will likely face its first recession since 1990.

It is important for those not familiar with emerging markets to understand the fact that a recession does not necessarily mean negative GDP growth in those countries. You just need to look at China and observe when the last negative GDP growth number was posted. Numbers are cooked by the government but even discounting that, I don't think China would have posted negative GDP growth in the last 30 years (I'm only looking at annual numbers.)
Back in 1990--arguably the last recession--real GDP growth was 3.8% but I don't think it will be that bad this time and expect closer to 8%. China has never had a negative GDP growth rate since 1976.


As for India, it can easily face an inflationary bust. It is one of the few high-growth emerging markets running a fiscal deficit and a current account deficit (in contrast, China, Russia, and Brazil have fiscal surplus and current account surplus (I didn't check recently but that was the case over the last few years.)) Foreigners have been financing everything for a while now, and if they stop channeling money into India, expect asset prices to plummet. On a P/E basis, India has been one of the most overvalued markets in recent years and can easily decline beyond what most expect (especially if earnings turn out to be peak unsustainble earnings.)


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Wednesday, September 24, 2008 2 comments ++[ CLICK TO COMMENT ]++

The Key Issue In The Bailout Is Not Executive Pay, But Risk To Government

The massive bailout being debated the US government seems to have taken a turn towards the absurd. It seems an inordinate amount of time is being spent trying to negotiate a requirement to curb executive compensation. The fact of the matter is that executive pay is almost meaningless in the grand scheme of things. Lest one forget, employee compensation is set by the shareholders and if shareholders are happy paying their executives high compensation for blowing up their firms, they should be allowed to. The government meddling will only create a bigger mess in the future. Sadly, the Democrats seem to think the executive pay is a big deal, while the Republicans (Paulson and Bush in particular) think it is worth fighting for this. Both should just forget about this issue and move onto the following.

The real issue is the risk taken on by the government and the proper compensation for that. The real discussion between the Democrats, who control the Congress and Senate, and the Bush administration, which seems to favour transferring huge sums from government to select individuals, should be the price that is paid by the mortgage asset sellers. The government should spend all its time trying to craft a deal where money isn't given freely to resurrect those who initially profitted immensely, only to blow everything up in the end, and are now running up to the government. The players who got us into this mess in the first place, not to mention investors such as Warren Buffett and Bill Gross (thanks to the Hackensack blog for article link) will try to spin the case and say that there should be no penalty. Paulson, being from the industry and an ex-Goldman employee and knowing that Goldman Sachs is one of the biggest benefitiaries from this deal would simply want to give away the money freely. The Democrats should drop all this posturing over executive compensation and deal with this latter issue.

I am of the opinion that a good deal would entail the government receiving contingent warrants for their purchase of the questionable mortgage assets. Perhaps create it so that the warrant is exercisable if the asset deteriorates significantly in the future (medium to long term; short-term price fluctuations should not matter). Such a scheme would automatically allow the government to re-capitalize these firms, which mostly likely would be in trouble if the situation deteriorated, when they exercise the warrants. Instead of the draconian 79.9% ownership seized by the government recently, the warrants here can be set based on the amount in question and the size of the firm. It can be as little as 10% or as much as 79.9%.

If the assets turn out to be good and recover their value, the seller loses nothing and ends up with valuable cash during a liquidity crunch; but if it turns out to be toxic, the seller ends up giving up a chunk of ownership in the business to the government.

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Hmm... Looks Like Warren Buffett Is The Latest To Attempt to Profit Off The Government

I highly respect Warren Buffett but he is just like everyone else in attempting to profit off everything. His latest investment in Goldman Sachs seems to be nothing more than an attempt to profit off the latest government plan. As Calculated Risk points out, Buffett says he wouldn't have made the investment if he didn't think the government plan was going to come to fruition.

I'm left-leaning so I am not as hostile as those on the right when it comes to government throwing around money. However, the $700 billion Paulson plan is very large and looks like it will benefit many firms that aren't even impacted much. Bloomberg had a story yesterday saying how Morgan Stanley and Goldman Sachs may be two of the biggest beneficiaries of the plan:

Goldman Sachs Group Inc. and Morgan Stanley may be among the biggest beneficiaries of the $700 billion U.S. plan to buy assets from financial companies while many banks see limited aid, according to Bank of America Corp.

``Its benefits, in its current form, will be largely limited to investment banks and other banks that have aggressively written down the value of their holdings and have already recognized the attendant capital impairment,'' Jeffrey Rosenberg, Bank of America's head of credit strategy research, wrote in a report dated yesterday, without identifying particular banks.


For those not familiar, these two banks are the least worries right now. Goldman Sachs has largely avoided the mortgage problems and Morgan Stanley, although badly hit, is better off than countless smaller banks. It would be ridiculous if most of the money went to these two instead of the smaller ones that need greater help.


As for the Goldman Sachs capital funding plan, it's not clear what the reason for it may be. As 24/7 Wall Street alludes to, this is a very expensive capital injection for a firm that didn't seem to need it. A 10% perpetual share (not sure if it's callable) is junk-like and very costly. Given the somewhat low valuations of Goldman, there is sizeable dilution (up to 20% for the full $10 billion). Unless you were desperate, selling off 20% of your firm doesn't seem prudent in my eyes.

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Monday, September 22, 2008 0 comments ++[ CLICK TO COMMENT ]++

New York Trying To Regulate CDS Written With Underlying Bond

Although it seems minor, this is actually major news. Bloomberg is reporting that the State of New York is attempting to require CDS contracts to be treated as insurance if the CDS buyer owns the underlying bond as well.

The state will treat contracts in which the buyer also owns the underlying security as insurance, Paterson said today in a news release. All such contracts would have to be purchased from regulated bond insurance companies, said David Neustadt, a spokesman for New York State Insurance Superintendent Eric Dinallo. Contracts in which investors buy protection against a default but don't own the actual security won't be treated as insurance, according to the release.


I'm not sure which insurers would be willing to write the CDS-type insurance. Forays into CDS writing by the monoline bond insurers ended up in a huge disaster. American giant AIG also blew up due to its CDS contracts. Admittedly, all these blow-ups are with mortgage CDS-type insurance, so other areas (interest rate, currency, corporate bonds, etc) may be ok. Right now we have non-insurance companies like Primus Guaranty (PRS)--incorporated in Bahamas--who write CDS, as well as hedge funds.

I think this attempt is going to be difficult to pull off. Insurance companies are heavily regulated and have strict requirements to hold sufficient capital, and this means it would take some time to get everyone set up. Capital seems to be scarce and the last thing anyone wants to fund right now is some insurance company writing CDS-type insurance.

All this may just be an attempt to stunt the growth in CDS. I don't work in the industry or anything, but my impression is that people are writing CDS as if it was going out of fashion, with little sense of the big picture. My guess is that if there are some "unexpected" events, a big chunk of the CDS writers are going to be bankrupt and won't pay up. This already happened in the mortgage bond area, as the following UBS case from last year shows:

In one notorious case, a small hedge fund agreed to insure UBS AG, the Swiss banking giant, from losses related to defaults on $1.3 billion of subprime mortgages for an annual premium of about $2 million.

The trouble was, the hedge fund set up a subsidiary to stand behind the guarantee -- and capitalized it with just $4.6 million. As long as the loans performed, the fund made a killing, raking in an annualized return of nearly 44 percent.

But in the summer of 2007, as home owners began to default, things got ugly. UBS demanded the hedge fund put up additional collateral. The fund balked. UBS sued.



Perhaps this is just an attempt to separate the CDS buyers who are buying it with the naive hope that the hedge fund or whoever that is on the other side will pay up if the bond defaults; from those that are simply using it to speculate or hedge various actions.

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Liberals Suggest They Might Scrap Income Trust Tax

The Liberals in Canada are suggesting that they are going to scrap the income trust tax, giving life to whatever is left of the trusts.

St├ęphane Dion's Liberals are promising to scrap the Harper government's hefty tax on income trusts as they release their campaign platform today, a pledge that offers a potential new lease on life for an investment vehicle much beloved by older voters.


I think this is a dumb idea and sounds like desperation. I hope they don't seriously pursue this. Some relief may be appropriate but allowing tax-avoiding trusts to be created is detrimental to the future of Canada. There is a reason such schemes are not prevalent in other countries, including USA. The fact of the matter is that many businesses will convert to a trust in order to avoid paying taxes, which also reduces re-investment in future growth and masks poor management.

I have never been fan of income trusts. I took a look at them about 3 years ago and came to the conclusion that they are risky in the long run. Most of them are of dubious stature. I mean, any time something yields close to 10%, you know that there is risk involved. Even the formerly popular oil&gas trusts are risky in my eyes. Most of them are money-making schemes for insiders and executives and will have problems replacing their production. I don't know if it was Charlie Munger who said to be careful with companies that try to avoid taxes. Tax-avoidance of the trust structure masks poor management performance and poor businesses. Even the royalty trusts (oil&gas) have been doing well because commodity prices have been going up. If commodity prices decline, many of the trusts will have serious problems (in contrast, non-trust E&Ps or integrated companies will survive.) I really feel that so-called seniors have been hoodwinked into these trusts due to their high yield.

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US Bailout Plan Needs To Be Modified

(Note: I'm not an American so this comment is simply my opinion of my neighbour to the South :) )

Ignoring the fact that I don't think the $700 billion US bailout plan is going to have much impact, I don't like the immense power being given to the Treasury. I'm not a fan of the Bush administration and we all know how much it loves to seize power. The bogus Iraqi war, started under complete lies is an example; another is the passing of the Patriot Act, which probably stripped more rights from Americans than the terrorists or the Nazis or anyone else that they faced before (fortunately, though, the Supreme Court isn't going alone.) Congress and Senate also play crucial roles in voting but the presidential administration is what sets the strategy.

I think the government needs to be really careful about giving too much power to the Bush administration (and the subsequent one after that.) Preliminary drafts of the proposal seem to give the Treasury, being run by Henry Paulson, immense power. Checks and balances may be limited in the private sector, with CEOs generally doing whatever they want with the board of directors sheepishly following along, but it's the norm for public officials, in this case being able to throw around $700 billion--a sum greater than even the bogus Iraqi war.

People don't realize how big this amount of money is--even for the US government. There is no way it should be given to the Treasury with very little oversight. Left-leaning Paul Krugman also shares a skeptical view, that is close to mine. If the government is going to give the money, at least do it with good oversight. Otherwise, it is easy to see big corruption problems with so much money being thrown around.

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Sunday, September 21, 2008 0 comments ++[ CLICK TO COMMENT ]++

The End of the Financial Sector As We Know It

This is pretty much the end of the financial boom of the last 30 years. A boom that started in the early 80's has finally run its course. GaveKal termed it the financial revolution and I agree it has been one. There have been immense benefits--easier access to credit; ability for public to own financial instruments; ability of businesses to off-load financial risk; more efficient hedging of financial risk; and so on--but all this will slow down in the future. It should be pointed out that the change that I'm referring to will occur not just in mortgage finance but in the full financial sphere.


Perhaps the best indication of the end is word that Goldman Sachs--the strongest investment bank in the world--and Morgan Stanely--another American giant in investment banking--are set to become bank holding companies. Although this does not mean that they will become a conventional bank, it does mean that the increased regulatory oversight will end their freedom. I anticipate two things from this. One, their leverage will be much lower in the future (hence shareholder profits will be lower.) Two, they won't be, depending on how you look at it, as nimble or reckless as investment banks had been over the last few decades.

If the strongest investment bank, Goldman Sachs, is facing threats--none of it fundamental and all from market perception of future--then it's the end of the current way of doing business.

Another harbinger of the end of the financial revolution is the beating G.E. shares have been taking of late. Whenever a megacap like G.E. drops 20% in one week (it recovered by the end of the week) it clearly means the market is re-thinking its future. A lot of people think of G.E. as an industrial giant but it has been coasting off financial profits for more than a decade. The New York Times alludes to this:

Yet General Electric is as much a bank as a blue-chip industrial company. Half of its profits come from its giant finance arm, GE Capital, whose global portfolio spans aircraft leasing, commercial real estate lending, credit cards and home mortgages.

Indeed, G.E. is the largest nonbank finance company in the United States, with assets of $696 billion and $545 billion in debt. If it were a bank, GE Capital would be the nation’s fifth-largest.


G.E. has very little exposure to subprime residential mortgages yet the market has been re-pricing its shares over the last year (the economic slowdown is also impacting the company but it alone can't explain the huge decline in share price.) The reason, I believe, is based on the view that future profits from financial operations won't be anywhere near what they were in the past.

G.E. relying heavily on financial profits is not a rare case in American industry. In fact, companies like GM and Ford derived a huge chunk of their profits (almost all the profits in some years) from their auto finance, mortgage finance, and credit card operations. There was a running joke a few years ago that these companies were finance companies and not car manufacturers. This is less so now since GM has sold off most of its finance divisions and others have pursued similar path. Nevertheless, it is an indication of how influential the financial sector has been on industry in general.

The important point being missed by some people is the realization that one of the main reasons for the decline in financial stocks is due to the market re-pricing their long-term future. Goldman Sachs, G.E., and others are not dropping because of losses on mortgages (both seem to have steered clear of the questionable residential mortgages and only seem to have limited exposure to commercial mortgages.) I see the financial sector shrinking relative to the rest of the economy. The implication for investors is that returns will likely be nowhere near they were in the past. Financial sector, particularly investment-related, has also been lucrative for employees but this is likely to be less so in the future.

(Do note that I'm talking about America here. The opposite is likely to be case in the developing world. There is still huge growth potential in those countries. For example, credit cards, public stock/bond ownership, retail financing, insurance, and so forth are still in their infancy in most of the populous Asia, Africa, Eastern Europe, and Latin America.)

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Saturday, September 20, 2008 8 comments ++[ CLICK TO COMMENT ]++

Mark-to-market Accounting Exacerbating The Collapse

I have been harping for many months that mark-to-market accounting, aka fair-value accounting, will go down as a culprit in the current financial crisis. I have upgraded my view and now think it will go down as one of the worst regulatory changes brought about by accountants in American history. Yes, that's how strongly I feel that it has exacerbated the crisis. I'm not an accountant or a financial analyst but sometimes those outside the field probably have a more neutral view.

Just to be clear, I am not arguing that it is the cause of the crisis! The cause is clearly mortgages given to people that couldn't afford them. I will also note that financial institutions benefitted 'on the way up' from this scheme. But it would have been better if they never benefitted on the way up no more than they suffer on the way down. What mark-to-market is doing is gravely exacerbating the situation.

John Mauldin seems to share my view and comments about it in this week's letter (requires free e-mail sign-up). Let me liberally quote a few of his key paragraphs:

(source: Betting on Financial Armageddon, By John Mauldin. September 19, 2008. Thoughts from the Frontline.)

Ratings to Collateral to Ratings: A Vicious Cycle

What's a recipe for a perfect financial storm? Let's make a massive amount of bad loans and get them on the books of most of the major financial institutions because they are rated investment grade. Then let's have the loans start to go bad. Throw in some general panic as everyone tries to sell the loans. No one is buying.

Let's make a new rule that you have to mark your illiquid securities to the last price paid by someone desperate to sell. That means that many institutions now have to mark their capital down and that means those pesky rating agencies must by their own rules mark down the ratings of the institutions which of course means that it costs them more to raise capital at a time when they can't get it which means they get lower ratings and so on. It becomes a vicious cycle.



Anyone following the financial firms would easily realize how much of a vicious cycle it is.

In the early 80's, every major US bank was bankrupt because they had loaned Latin American countries far more than their capital they had on their books. The Latin American countries defaulted. If the US banks had been forced to mark to market, they would have all gone down taking the US economy along with them. So, the Fed simply allowed them to carry the loans at book value, offering liquidity and allowing the banks to buy time to make enough money to eventually write off the loans.


Although Mauldin implies that the main benefit would be to let the businesses earn their way back, my main reason is the belief that the assets are better off than market price. Since everything is opaque and complicated, everything is being lumped into the same category and no one wants to touch them. Some institutions will take massive losses and may even go bankrupt but the losses should be far less than the market perception. To see what I mean, consider the cases being reported in the media where prime borrowers are unable to finance their homes. Everything related to housing is being treated the same even though they are not. If the word stereotyping applied to investing, this is it.

It is one thing to require that you mark your stocks or bonds to market values. It is another thing entirely to require all mortgage backed securities, which are extremely complex things, can be very different one from another and which require a lot of time and effort to value, to be priced as though they are all the same.

FASB 157 needs to be amended this week. If Congress can create a new Resolution Trust Corp in a week, the surely the accounting board, with the suggestion of Treasury, can figure out a better way to price illiquid securities.


Too late, I think. Accountants are a slow moving bunch anyway. It's probably too late for the housing problems. However, something needs to be done in the future. There are a lot of so-called level 3 assets which have nothing to do with mortgages and fair value accounting will start causing problems there in the future. Instead of spending time worshipping efficient markets, the accountants and their body should focus their time on trying to develop ways to value illiquid assets. If the accounting framework fails for the level 3 assets, it will may bankrupt the commerical banks--those that avoided the housing problems.

Again, to reiterate, bad assets will result in losses no matter what. I am not suggesting that bad assets should be treated as if they are good; rather, my point is regarding the unfortunate circumstance where everything, including good assets, are lumped into the bad assets and priced based on some depressed market price. Pricing everything based on market price may make sense from an efficient market point of view, but reality is anything but.

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Ambac Facing Serious Problem With Its GIC Business; Postpones Connie Lee Idea

It seemed like Ambac solved its short-term problems a few months ago but that was not to be. It seemed unlikely a few months ago but the suggestion by Moody's this week of a rating downgrade will cause serious problems for Ambac. The situation is very similar to what brought down the insurance giant AIG (however, AIG's problem was with its actual insurance issued in CDS form, whereas Ambac's problem is its side investment management busines). Namely, it looks like Ambac will be short if it had to post collateral, as required under its GIC contracts.

Ambac will be short by $1 billion to $2.1 billion (based on present market values), depending on the company rating. Now that it has shelved its Connie Lee idea--I was never a big fan of this--it should have around $850 million. I think its easy to get $1 billion but $2.1 billion could be tough and would require approval from the insurance regulator.

What is happening is that the market value of the assets are down (not surprsing given the market conditions) but since the company rating is being cut, it is requiring a greater amount of collateral. These assets were set up to be held to maturity and the assets seem to be ok quality (my guess is that if they were held to maturity, they would not result in losses), so it's not really an asset problem per se. Rather the whole investment management business was set up assuming that the company would have high ratings. This shows the perils of building a business without considering a seriously negative scenario (in this case a ratings downgrade.) It would be quite ironic and sad if Ambac's survives the subprime mortage insurance problems but somehow goes down because of its investment business.

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Friday, September 19, 2008 0 comments ++[ CLICK TO COMMENT ]++

Huge Rally Today But Unlikey To Be Sustainable

The rally today was massive. The TSX was up around 7%. Here is a sector snapshot of the Dow indexes (courtesy wsj.com):



I think the rally is bogus and unsustainable. Part of the rally is due to the elimination of short selling of financials. As you can see in the chart above, the big gainer was financials. The second best seems to have been energy. A lot of short sellers likely covered their positions in case the SEC extends the shorting ban to other industries.

Overall, we finished the week largely flat in most countries but, needless to say, it was beyond a wild ride.

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LOL Russian Market Halted Again--This Time Because It Went Up Too Much

Russian market was halted again... this time because it rose 30% in one day:

Russian stocks rallied nearly 30% Friday, causing the markets' regulator to halt trading once again on the two main stock exchanges, after the government took a series of steps aimed at stemming the country's financial turmoil.


I think emerging markets can still sell off in the next few months.

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Consequence Of The Short-selling Ban On Financials

UPDATE: ProShares says that no new shares will be created but existing ones can be liquidated. One of the advantages of ETFs is supposed to be their inherent arbitrage which keeps their share prices close to the net asset value but that is going to be out of whack now that arbitrageurs can't create new shares of the ETF.

Here is a consequence of the financials short-selling ban. The Ultrashort Financials ProShares (SKF) isn't trading:



I have no position in it but just pointing out some results. I suspect that the derivatives market--such as those writing options--will also see less liquidity (since writers often hedge their derivatives position by taking long or short positions in the underlying stock.)

This isn't a big deal (except for those bears who need to get their money out) but it's something that may happen to other stocks. I never would have thought this possible a few weeks ago but it is quite possible for the stock market to shut down. I'm not expecting it to happen in America or Canada but things are nowhere near normal.

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US Plan Probably Will Not Work

The free market is becoming less free, that's for sure. It's quite ironic that the "free market" Republicans end up undertaking huge socialization programs. Congress and Senate are controlled by Democrats but the Treasury is run by the Republican president. Having said that, I think the Democrats would have done something similar, but perhaps with a greater cost to investors and less so to taxpayers. This post is about the proposed strategy for the US governmen to buy distressed mortgage assets. But first some key events that are unfolding.

The SEC just banned short selling on 799 financial stocks. Financials will rally but it's not a market signal. It's close to a manipulation so it's questionable if the rally is temporary. I'm not sure what happens with inverse ETFs. Does this mean that no new ETF shares (of short funds) will be created? You are going to get some unpredictable results from the shorting ban.

The US government is also creating a $50 billion insurance fund for money market funds. Participants in this insurance scheme need to pay the government a fee so it's not clear if it is retroactive. That is, some money market funds bought assets that have and will face permanent impairment (eg. Lehman Brothers unsecured, junior, bonds) so will the insurance cover funds containing questionable assets? This is probably a good idea since banks tap money market funds for capital, not to mention cross-sell other services to money market depositors.

Anyway, the big news is word that the US government is proposing to buy illiquid assets which are generally of dubious quality. We don't know the details of the actual mechanics of the proposal but although it will be benefitial at the margin, I'm quite skeptical. Calculated Risk speculates on the the nature of the entity and let me quote some insightful items.


However this new entity would be very different from the RTC in a number of ways. The RTC was created to dispose of assets accumulated from failed Savings & Loans.

The new entity, according to the WSJ, would purchase illiquid assets "at a steep discount from solvent financial institutions and then eventually sell them back into the market".

With the RTC, the government already had direct responsibility for the assets since they acquired them from insured S&Ls that had failed. The role of the RTC was to liquidate certain of these assets.

In the current situation, the government has no financial responsibility for the assets, except for a few exceptions like the assets of Fannie and Freddie, and the NY Fed's assets acquired in the JPMorgan / Bear Stearns deal. The new entity will both buy assets "at a steep discount" and eventually sell the assets. So unlike the RTC, this new entity puts the taxpayers at risk.


I'm not an expert but I guess the RTC from the 1990's can be thought of as a liquidator while this new entity can be thought of as an investor. This means taxpayers are at risk.

If this is how the entity behaves--we are just guessing here--I already see one big problem. Why would any owner of these illiquid assets sell them to the government at a depressed value? Note that the S&L case involved failed/already bankrupt firms so they would have sold them for sure (i.e. they would have behaved like liquidators and tried to get rid of assets.) Here the institutions that own it will only liquidate if they can get a price that is better than their mark-to-market value (let's assume that one also doesn't think it will deteriorate further.) It depends on the price but if we assume that the government will not offer any more than the presently depressed market price, there is little incentive for the owners to sell them. Instead, the banks, insurers, and others, are likely to roll the dice and hold the assets, hoping that they perform better than the market thinks. The exception might be assets where the government pays more than what the bank thinks the assets are worth. Since illiquid assets are hard to value, the owners will have greater knowledge than the government entity.

Another previous entity mentioned today was the Reconstruction Finance Corporation (RFC) that was created in 1932 by Hoover. A key purpose of the RFC was to purchase preferred stock in banks to increase their capital positions and expand their landing [sic] capacity.


I'm not really sure what will happen in a situation like this. The problem is that it is not in shareholder interests to raise capital via share issuance (preferred or common.) The market price of the distressed firms are so low that any capital injection by the government via preferred shares can result in literal nationalization. Buying as little as a few billion of preferred shares in some of these firms can result in the government owning more than 50% of the company. Again, why wouldn't the company roll the dice and hope that the assets recover (rather than accepting the government preferred shares)?


I think the proposed solutions will help a little bit but it will likely have marginal impact in the long run. The ultimate solution has to come from Fannie and Freddie. I think if they can continue to lend, while avoiding shoddy mortgages, it will keep the current and future mortgage market going. The past--those who own the questionable mortgages--simply have to let the market decide their fate. Many of them will go bankrupt but that's due to their own past mistake.

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Thursday, September 18, 2008 2 comments ++[ CLICK TO COMMENT ]++

"The Markets They Are A-Changin'"

Found the following song lyrics set to Bob Dylan's The times they are a-changin'. I don't agree with the full lyrics but it's well done so I'm reproducing it here. If you are not familiar with the original song by Bob Dylan, check out the song on YouTube. (For those not familiar, Bob Dylan is an American rock & roll musician and is considered to be one of the most influential of all time. His most famous song is Like a rolling stone (youtube link here).)

Posted by williambanzai7 in the comments on the NYT DealBook blog for the entry Henry Paulson's Frakenstein. I assume he/she is also the author of the modified lyrics. Reproduced without permission.

The Markets They Are A-Changin’
(to the melody by Bob Dylan; posted by williambanzai7)

Come gather round ‘bankers’
Wherever you roam
And admit that the waters
Around you have grown
And accept it that soon
You’ll be told to go home
If your job to you
Is worth savin’
Then you better start swimmin’
Or you’ll sink like the DOW
For the markets they are a-changin’.

Come hedgefunds and bear traders
Who prophesize and sell short
And keep your eyes wide
The chance won’t come again
And don’t speak too soon
For the markets still in spin
And there’s no tellin’ who
That it’s namin’
For the markets they are a-changin’.

Come senators, congressmen
Please heed the call
Don’t stand in the doorway
Don’t block up the hall
For he that gets hurt
Will be he who has stalled
There’s financial meltdown outside
And it is ragin’
It’ll soon shake your windows
And rattle your walls
For the markets they are a-changin’.

Come Central Bankers
Throughout the land
And don’t criticize
What you can’t understand
Those derivative books
Are beyond your command
The old road is
Rapidly agin’
Please get out Bernanke and Paulsen
If you must bail them out out
For the markets they are a-changin’.



BTW, I actually don't think the markets are changing... what is happening is what has happened and will happen... but I like the creativity that went into the song adaptation :)

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Great Time to Invest According to Martin Whitman

It's a great time [to invest]

-- Martin Whitman, on the current market meltdown



Others may not quite share the enthusiasm but Martin Whitman, speaking at an investment forum in Toronto yesterday, thinks it's a good time to invest and reckons it's similar to 1974:

"We can't try to pick the bottom, but it seems to me that there are great values out there now, just like in 1974," the firm's co-chief investment officer said in an interview.

The stock market crash of 1973-74, which affected all the major stock markets around the world, lasted 694 days before bottoming out.

"Everything went down every day, and if you bought, you hit a lot of 10-baggers," recalled Mr. Whitman. "I hope that we do it with a lot of what we are doing now."


One may recall that the 1973/1974 period was marked by a severe recession, with commodity prices going out of control. This time, however, we have a real estate bust, along with a potential credit contraction. If I recall correctly, the big bust in the stock market back then was in the Nifty Fifty. Right now, the bust is anything to do with real estate, and financials in particular. The interesting thing right now is that the economy is not bad.

Nothing new in the article for Martin Whitman followers but it's always good to get his feel on the situation.

"If the value is compelling enough and the businesses have staying power, we just buy and don't worry about the market," Mr. Whitman said.

"Our turnover is about 10 to 15 per cent a year at most, and the majority of our exits are companies that get taken over rather than a sale."


Synchro, a reader, or other non-value investors will never comprehend what Whitman does. He, like most value investors, buys without considering the market behaviour.

Whitman leaves us with the reassuring words immortalized by Benjamin Graham:

It's worse than the U.S. savings and loans crisis in the 1980s, Asian currency crisis of 1997 and the collapse of hedge fund Long-Term Capital Management and the Russian default crisis in 1998, he said.

But, he said: "This too shall pass."

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Wild Day... Make That Week

I remember when I was following Ambac early in the year, practically every day was wild. Well, now the whole market is wild. There is so much happening--many of which reek of desperation and I don't approve of--that you can literally read stories all night long. Here are some I find useful to know about...


  • Moody's may downgrade Ambac and MBIA: Ratings don't matter to the monolines anymore since they aren't writing any business, with one exception. That exception is that rating downgrades generally require collateral posting for their investment business... I have been so busy with non-bond-insurer information that I don't even know what happened today. MBIA was up 40% today on no published news. Could be short covering but it's not clear.
  • Some American pension funds stop lending shares: CALPERS, a large California pension fund, and others are supposedly refusing to loan shares of selected financial companies like Morgan Stanley and Goldman Sachs. Recall that short sellers have to borrow shares from someone who owns it.
  • Presidential candidate, John McCain, would fire SEC Chairperson Cox: This is a totally misguided move. SEC has very little control over what is happening and clearly McCain doesn't understand the root cause of the problems. The problem really stems from the mortgage sector and the SEC has little control over it. Some of the banks are failing because they own bad mortgage assets and the market doesn't trust them. SEC is quite limited and whatever they can do, like limiting short selling, accomplishes very little in the long run.
  • China lets its SWF buy Chinese bank shares: Another attempt to prop up the stock market that is bound to fail.
  • The big news is the rumour that the US government is planning to buy up the bad mortgage assets: This can work but won't stop some from going bankrupt.

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Wow, Britain Bans Short Selling of Financial Stocks; Russian Markets Still Halted;

This is unbelievable. FSA, the British regulator, just banned short selling of all financials. I have been in favour of banning naked short selling but this is a dumb move. It goes against everything good about a free market and it is going to result in unpredictable outcomes. Possible problems include liquidity completely drying up for financials, difficulty for market makers (particularly derivative players such as option sellers) in hedging, and decline in trust by investors.

In another note, the two exchanges in Russia still seem to be halted. The government is injecting liquidity into the market, as well as cutting oil taxes. This is another strategy that can easily backfire with rampant inflation in the future.

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How Legal Is the AIG Takeover?

That's a question I have been wondering. The AIG takeover does seem quite murky. Steven Davidoff, writing for the Deal Professor (NYT's DealBook) raises important questions pertaining to the takeover. He also suggests some answers for why things may be what thye are. From my layperson perspective, it certainly looks like some shareholder rights were run over by the steamrolling government. However, this does not mean that AIG shareholders would end up with more money in alternate scenarios. It looks as if AIG did not raise $14.5 billion they would have filed for bankruptcy. Nevertheless, this deal raises all sorts of questions.

I highly recommend reading the linked article when you feel like it. Newbies like us, who never worked in the industry, can learn a lot of the legal rights of shareholders. So even if AIG has nothing to do with you, the issues raised may help you in your future investments. I will warn, however, that laws are dependent on the jurisdiction so one shouldn't expect the same in, say, Japan. Roughly speaking, America probably offers the strongest property rights. This is doubly so for corporations incorporated in Delaware, like many are (I'm not a lawyer but Delaware is supposedly attractive due to its flexible law for businesses, no juries, large existence of past cases).

Let me quote the key issues raised by Steven Davidoff:


On the so-called Revlon Rule...

In the A.I.G. bailout, the Federal Reserve is taking 79.9 percent of the company, reportedly in warrants. A.I.G. is a Delaware company and so, in normal times, Revlon duties would apply to A.I.G.’s board. This would forestall A.I.G. from simply issuing out this controlling interest; instead, the A.I.G. board’s fiduciary duties would require it to obtain the highest price reasonably available for the company. It might be that, in these circumstances, the board actually did satisfy its Revlon duties in that there was no other price available.

In any event, A.I.G. likely also justified this issuance as an exemption from Revlon requirements under a second doctrine concerning board duties in the “zone of insolvency.” This doctrine purportedly permits the board of an insolvent company to take actions in the best interests of creditors and shareholders to protect the company itself, even actions that may be contrary to Revlon duties.



On shareholder vote...

Where is the shareholder vote here? If the Fed is indeed taking a 79.9 percent interest in warrants, A.I.G. still needs a sufficient number of authorized shares to make this share issuance. However, A.I.G. only has 5 billion shares of common stock authorized and approximately 2.67 billion outstanding. To issue enough shares to support the warrants, A.I.G. shareholders would need to approve an amendment to A.I.G.’s certificate of incorporation to authorize the issuance.


On NYSE rule requiring shareholder vote for major ownership change...

Similarly, NYSE Rule 312 requires that shareholders approve any common stock issuance when the common stock will have voting power equal to or in excess of 20 percent of the voting power outstanding before the issuance of such stock.

Here, A.I.G. will no doubt rely on the rule exception that applies if “the delay in securing stockholder approval would seriously jeopardize the financial viability of the enterprise.”


On AIG issuing debt somehow more senior to existing senior debt...

Some are wondering about A.I.G.’s other senior debt. How can the Fed take seniority to that debt and security over A.I.G.’s assets and not trigger the covenants in the other debt, which prohibit such events?

A.I.G. actually has not filed its indentures for the debt. Instead, they rely on an exception in Item 601(b)(4)(iii) of Regulation S-K that allows A.I.G. to omit filing such debt if, in the aggregate, it constitutes less than 10 percent of its total assets. At some point the Security and Exchange Commission needs to close this loophole.



My personal opinion is that Henry Paulson shouldn't have given the AIG CEO the $7 million golden parachute. I really feel that management was totally incompetent (not just the present one, but the prior CEO, Greenberg, under whose watch most of these questionable CDS insurance on CDOs was written) when it comes to running the business and it's ridiculous to get a big pay package. It's crazy to imagine that a $14.5 billion cash flow shortage put a company with a trillion in assets into near-bankruptcy.

Oh, if anyone wonders why the government is taking 79.9% ownership in AIG (same in Fannie and Freddie,) it's supposedly because, otherwise, the government has to consolidate the balance sheet of the companies into its own government balance sheet. Taking a less than 80% stake allows the government to avoid brining in the debt (and assets) of these companies onto the US balance sheet.

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AIG Kicked Out of DJIA Index; Replaced With Kraft

I always felt that GM would be the one that would get kicked out of the Dow Jones Industrial Average first but I was wrong. The Wall Street Journal is reporting that AIG is being replaced by Kraft. AIG somehow manages to collapse 90% within a few months while GM miraculously survives some tough conditions in the auto industry. It's truly amazing in my eyes. I would have thought that diversified insurers would be stronger than investment banks or monoline insurers, but guess not--at least in the case of AIG. I lay most of the blame of AIG in the hands of management. This is a classic case of a few executives running the company into the ground. AIG would have faced losses and performed poorly regardless but management pushed it over the edge and actually managed to almost bankrupt it.

The DJIA should be more stable with Kraft. I don't see great prospects for Kraft so the DJIA will probably lag in the future but it won't suffer losses or be as volatile. If I'm not mistaken, DJIA is a price-weighted index so Kraft with a price of around $33 will have greater impact on the index than Microsoft ($25ish.)

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Wednesday, September 17, 2008 1 comments ++[ CLICK TO COMMENT ]++

Risk Arbitrage: Teck Caminco Takeover of Fording Canadian Coal Trust

With the BCE deal seemingly on the ropes (stock is off another 8% today), it may be questionable to consider risk arbitrage but now may actually be a good time. I am looking at the Teck Caminco--a Canadian mining giant--takeover of Fording Canadian Coal Trust (FDG; TSX: FDG.UN). The stock is trading way below the cash portion of the offer but there are many question marks about financing. The latest suggestion by the Teck CEO that other coal users, such as steel producers, may finance the deal seems like grasping at straws.

The risk with this deal is that Fording is trading at rich multiples given the commodities bull market over the last few years. The stock is up 100% in the last year so it's not clear to me what the downside is in a failed takeover (in contrast, something like BCE has a definable downside of about $30 per share.)

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The Unthinkable May Happen (Although I Don't Think It Will): Downgrade of US Soverign Ratings

What are the chances of USA's debt rating being downgraded? The unthinkable may actually happen at some point within the next 10 years if USA goes down the current path. S&P says that USA's balance sheet has weakened:

Pressure is building on the pristine triple-A rating of the United States following a federal bailout of American International Group Inc., the chairman of Standard & Poor's sovereign ratings committee said Wednesday.

The $85-billion (U.S.) bailout of AIG on Tuesday by the U.S. Federal Reserve “has weakened the fiscal profile of the United States,” S&P's John Chambers told Reuters in an interview.

“Lack of a pro-active stance could have resulted in further financial stress and put pressure on the U.S. triple-A rating,” Mr. Chambers said. “There's no God-given gift of a 'AAA' rating, and the U.S. has to earn it like everyone else.”

...

Ten-year credit default swaps, or CDS, on Treasury debt widened three basis points to 26 basis points, according to data from CMA DataVision. This means it costs $26,000 per year to insure $10-million of U.S. Treasury debt against default.

Five-year credit default swaps on Treasury debt were steady at 21.5 basis points. That compares to 9.8 basis points on German five-year CDS and 13.2 basis points on German 10-year CDS, CMA said.


USA is nowhere near being downgraded but it's amazing to think that they are even in a position for that thought to be entertained. As Jim Rogers has pointed out numerous times, England was essentially bankrupt in the 70's even though no one would have thought that possible.

Gold is rallying big time today and I guess it's obvious that some think that the FedRes is going to print money. I really hope that they don't. They have done an excellent job injecting liquidity into the system without printing money so far. It would be a shame if they started inflating their way.

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Well, At Least SEC Improved On Its Latest Naked Short-selling Crackdown

Well, the SEC re-instituted its naked short-selling ban. The prior ban was a joke, not because I am against it, but because it limited it to select financial stocks. The new ban is for all stocks.

Short selling is fine and helps markets but I am against naked short selling. Selling more shares than are available impacts firms that depend on capital markets for funding. Typically financial institutions, penny stocks, resource companies, and tech/biotech start-ups are hurt by naked short-selling. This ban should have been instituted many years, or decades, ago. Patrick Byrne of Overstock (OSTK) has been harping for years about how naked short selling was hurting his company. Who knows if naked short selling is the reason for Overstock's struggles but if it wasn't widespread, it wouldn't even be in a discussion.

The cynic in me says that this change is going to have little impact. SEC doesn't have the resources to enforce it. But if someone is ever caught, they will pay a price now.

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Hussman: Lehman Customers and Counterparties Should Be Fine; Ambac Has Minimal Exposure to Lehman

In his latest commentary, John Hussman says that customers and counterparties of the bankrupt Lehman Brothers will be fine. He points out an oft-ignored detail that, although Lehman was backing $600 billion of assets with only $20 billion on common equity, there is $100 billion of bonds backing the firm. So, the $100+ billion from bondholders should be able to cover losses. The chance of customers or counterparties losing money seems slim.


But I'll repeat what I wrote about such issues in the April 7, 2008 comment:

“In any event, SEC Chairman Cox is right – Bear Stearns' customers and counterparties were never at risk of loss. Though counterparties don't have the SIPC protections, they did in the Bear Stearns instance have a substantial capital wall and legal safe harbors specifically designed to limit systemic problems. There was a willing buyer for Bear's entire book, so the book didn't need to be unwound, just sold in its entirety on day one. Major U.S. financial companies have enough capital (shareholder equity and bondholder debt) to provide a cushion in the event of substantial writeoffs, without customers or counterparties being at risk of loss in the event of outright bankruptcy. The only instance where there would be a question would be if the book value of the failing company was negative after entirely zeroing out all shareholder equity and bondholder debt, or if the only way to liquidate the book was to unwind it. That was not the case for Bear Stearns."

...

In Lehman's case, $20 billion in shareholder equity is a very thin pool of funds to eat through when you're not confident in the true market value of the $600 billion in assets held by the company. But it's crucial to recognize that if you include both shareholder equity as well as Lehman's debt (bonds and subordinated debt), you've got a $143 billion cushion to eat through before any customer or counterparty would be at risk. With that kind of cushion, the issue is not, and probably will never be whether customers or counterparties are at risk. The only issue is whether you save the bondholders.


John Hussman, like myself, is not a fan of the Bush tax cuts. When all is said and done, the George Bush administration, along with Alan Greenspan, who was promoting the tax cuts, are going to end up destroying a chunk of America.

Essentially what we've got here is an economy where the government provided a boatload of tax cuts, the benefit of which was invested directly and indirectly into mortgage securities, which helped to finance irresponsible lending, which produced a housing bubble, and now that the bubble has burst and the mortgage securities are losing money, those same bondholders are looking for the government to bail them out.

That's messed up.


I second that. It's ridiculous to save bondholders when shareholders lose everything. Ideally, both--shareholders and bondholders--were responsible for profitting from these firms and deserve whatever their fate is according to the free market.


Ambac Exposure to Lehman

Ambac also outlined its exposure to Lehman Brothers, which seems quite small:

Ambac’s direct exposure to Lehman is limited to six interest rate and currency swap transactions where Lehman is the swap counterparty. Ambac has an insignificant net current payable balance, to Lehman. Ambac is exploring contract termination options to mitigate against any future credit risk to Lehman.

Ambac has no direct Lehman exposure in its financial guarantee or financial services investment portfolios. In addition, Ambac has no financial guaranty or CDS obligations related to Lehman. Ambac has reinsured surety exposure covering operational risk of lost or missing customer assets, not market value declines, at several broker-dealers, including Lehman Brothers, with a maximum aggregate exposure of $137 million. Ambac is not aware of any lost or missing customer assets at this time.

Ambac has indirect exposure to Lehman in two ways:

1. Ambac’s Financial Services business has approximately $1.3 billion in outstanding GICs backing Credit Linked Notes where Lehman is the CDS counterparty to the transaction...

2. Ambac also has exposure to structured and municipal transactions where the issuer may have entered into a swap or a GIC with Lehman as a counterparty...


As John Hussman pointed to above, it is likely that customers and counterparties will be fine. Lehman has to eat through $143 billion of capital before customers and counterparties take losses.


(On another note, Lehman is well on its way to being liquidated. Barclays just picked up the investment banking operations (without much mortgage exposure) for $1.75 billion. Most of the money is for the building. )

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