Saturday, December 20, 2008

2x ETFs

Lately, I've been fascinated by the double-short ETFs like SRS and SKF. I have yet to see an analysis of these vehicles that made sense.

These ETFs track (and compound) -2x the daily swing in the underlying index. Several folks have already mentioned that volatility acts against the long holders of these securities. I am searching at the moment for a quantification of the volatility reduction, but have found nothing as of yet.

Perhaps I will have some spare cycles over the holiday. In the meantime, any pointers are welcome.

Thursday, October 23, 2008

Why The Bailout Is Failing

The equity markets have passed judgment: The Bailout is Failing.

The current list of Bailout Failure symptoms is large: Declining markets, historically large spreads, and etc. The underlying cause of all of these symptoms is that confidence in the financial system has been shattered.

Sadly, several Fed actions have exacerbated the situation. For instance the Fed has proposed numerous facilities to jumpstart credit. Naturally, every time a new facility is introduced, a portion of the credit sector shuts down, since no sane business would ever continue issueing credit in competition with the Fed. As parts of the credit food chain are subsumed by the Fed, businesses shut down their operations in the next part of the credit food chain, which the Fed has just made nonviable. Consequently, the Fed needs to create another facility for that newly shut down operation. And so on.

Underlying all of these issues is the fact that there are many insolvent institutions. Ben Bernanke, who is a student of the depression, knows well that runs on financial institutions occurred due lack of confidence in the 1930s. Once the system was reflated in 1933-4, reconstruction could begin.

However, it seems lost on him that a major aspect of the reflation is that the insolvent institutions had already been removed from the system by 1934. At the moment, there seems to be not even a whisper of shutting down the large banks that were so incompetent that they drove their businesses into bankruptcy. We are even rewarding those institutions by augmenting their shareholders with government capital. (Let's face it: It's not likely that these banks are going to suddenly grow new neurons and become smart and sensible operations.)

We should not expect any real change until we remove the rot from the system; it is the underlying cause.

Tuesday, October 14, 2008

Paulson Capitalism

Welcome to the new banking system in the United States. A quick scan of the headlines will tell you that major banks are being partially nationalized. You may remember that this nationalization is in response to the fact that they are insolvent.

Most businesses do not strive to achieve insolvency. In the case of the banks, they managed to find themselves in this state by being badly mismanaged and making poor investments.

The UK recently taught Paulson that (a) his plan to prop up balance sheets by buying toxic waste was flawed (in truth, he just has a big conflict-of-interest as former CEO of Goldman-Sachs) and (b) government taking equity was the proper way to inject capital. The UK version creates obvious dilution for the shareholders and takes board seats in order to clean house of poor management.

Secretary Paulson, in his infinite wisdom, has decided that the current banking management is just fine, their results are not worthy of castigation by firing squad, and that shareholders are to be "protected". Like many statements from the Bush administration, you need to spend time to figure out how they are torturing the language in order to see through to the truth. The truth here is that Paulson is diluting the shareholders as well as addressing symptoms rather than the cause.

The bailout details are actually pretty simple. The Treasury will inject 20-25 billion dollars in each of 9 major banks and take out "perpetual preferred" stock. In the event of bankruptcy, or receivership, these shares stand ahead of the common shares. The shares also pay a dividend. From the NYT:
The preferred stock that each bank will have to issue will pay special dividends, at a 5 percent interest rate that will be increased to 9 percent after five years. The government will also receive warrants worth 15 percent of the face value of the preferred stock.
By any reasonable definition of dilution, shareholders should be angry about the warrants. It means that any future increase in stock price will be shared with the government (who will sell those shares and drive the price down.)

From the viewpoint of the economy, the most interesting part of the deal is the 5% dividend. By forcing the banks to take this money, they need to earn at least 5% on the money in order to turn a profit. So they collectively need to figure out $250B in investment deals. Naturally, since they have proven themselves to be such good investors in the past (why do they need a bailout?) they will scour the planet in search of returns. The alternative is for management to find quick investments, continue cooking the books (mark-to-market rules are now suspended), collect bonuses and have cushy jobs. Which do you think is the more likely outcome?

In summary, Paulson thinks that the same management with a demonstrated capacity to lose a trillion dollars is going to somehow grow new neurons and be smarter with the taxpayer's $250B. Good luck with that.

Monday, October 13, 2008

Heckuva Job, Brownie! (Gordon Brown, of course.)

1. For Gordon Brown, I just have to say: Heckuva job, Brownie. Really.

2. England just schooled Hank and W on how to execute a honest-to-god bailout, not the Friends of Hank bailout that was passed by congress a mere 10 days ago.

3. Now that British banking is more secure than US banking, expect the giant sucking sound of money leaving the US for Europe until either Hank wipes out US bank shareholders with partial nationalization or Obama takes office.

Why is Hank avoiding this solution? Look at the share prices of the banks that received gov't money: They were pummeled. Hank would be wiping out many of the colleagues on Wall Street that helped make him CEO of Goldman-Sachs. He just doesn't have it in him.

Monday, October 6, 2008


I will be experiencing life on the road for the week of Oct6-Oct10. I hope for some live, action photos of the TARP rescue working its magic on middle America.

Thursday, October 2, 2008

You Have Been Officially Shafted in this Trainwreck

Perhaps you've heard that the Senate decided to pass the trillion-dollar bailout bill that the House rejected earlier this week. Obviously, our wise and prudent Senators would not be so foolish as to pass that old rejected bill with its stale and unfashionable provisions. That would be an insult the House. Therefore, changes were required.

If you watched the CSPAN debate over the bill Wednesday night (you really need to get a life, don't you think?), you were treated to much bloviation about trains. As the public has been told repeatedly, the Welfare for Wall Street bill is maximally urgent. We can only assume that the elongated discussion about trains is to prevent this legislation from causing the very trainwreck which it seeks to prevent. Sadly, I was unconvinced.

As my mind wandered from the wise words spoken on the floor of that hallowed chamber, I decided to see what modifications might have been added. Via the most excellent Calculated Risk and Naked Capitalism blogs, we find the heart of the changes:

(a) IN GENERAL.—Paragraph (2) of section 4161(b) is amended by redesignating subparagraph (B) as sub301 paragraph (C) and by inserting after subparagraph (A) the following new subparagraph:

‘‘(B) EXEMPTION FOR CERTAIN WOODEN ARROW SHAFTS.—Subparagraph (A) shall not apply to any shaft consisting of all natural wood with no laminations or artificial means of enhancing the spine of such shaft (whether sold separately or incorporated as part of a finished or unfinished product) of a type used in the manufacture of any arrow which after its assembly—

‘‘(i) measures 5⁄16 of an inch or less in diameter, and
‘‘(ii) is not suitable for use with a bow described in paragraph (1)(A).’’.

(b) EFFECTIVE DATE.—The amendments made by this section shall apply to shafts first sold after the date of enactment of this Act.
I realize that the Senate is voting to bail out banks and shaft the next three generations of Americans, but I really never expected them to say it this plainly.

Then, came the exciting moment: The moment where voting occurs and we watch democracy in action. Apparently, the Senate was never wired for electricity, because while we are hearing about urgency (OMG! HARRY REID SAYS THAT A MAJOR INSURER IS GOING BANKRUPT SOON! WE NEED TO PASS THIS NOW!) these wise men and women cast their votes in the same manner as the Greeks, by calling out a name and writing longhand on a piece of paper. I really don't understand why we think that 100 grown men and women that can't bring themselves to vote electronically have any insight into how to spend a trillion dollars on bailing out Wall Street.

Seriously folks, if you want any hope of the House dealing with this problem of our generation in an intelligent and just manner, you need to call your representatives at (202) 224-3121 and threaten to vote them out of office next month unless they ditch the current plan. The fundamental flaw is that the plan still has the structure proposed by Secretary Paulson, former CEO of Goldman Sachs, who will profit handsomely from this legislation. He is sending a gift to banks for making bad investments.

There is an age-old and intelligent way of dealing with insolvent institutions, and Paulson is avoiding these solutions, as it would bankrupt many of his colleagues. However, if we are to restore confidence in the banking system, we need to clean house, not buy crappy assets above market value. The current solution will only convince investors to leave the market, selling their stock as they go.

We cannot coddle the failures on Wall Street: If you have a bad company that is taking down the financial system, wipe out the shareholders, haircut the bonds, fire the board and CEO, recapitalize, and reboot.

Wednesday, October 1, 2008

U.S. Decline Under Bush Is Hot Topic at U.N.

The Paulson bailout is beginning to have ripple effects on world affairs:U.S. Decline Under Bush Is Hot Topic at U.N.:
"Not only are U.N. diplomats worried about the spillover of financial damage to their markets, but they find a free market-oriented administration's full-throated backing of a highly interventionist bailout galling, coming after years of Washington hectoring other countries about maintaining economic prudence and counseling against debt bailouts.

'Here's the U.S. engineering the mother of all bailouts,' marveled the diplomat. He says diplomats believe that poor Bush administration policy choices, the lengthy and unresolved military engagements in Iraq and Afghanistan, and the general rise of powers like Russia, China, and India have all eroded U.S. power in relative terms."
Now, I'm not much of a political creature, but if the current administration offered to leave, I'd offer to help them pack.

Forget the history of the past 7 years for a moment. If you were designing a financial intervention, what would it look like? I think good business leaders would try and rip the band-aid off quickly, rather than augment it with duct tape. Certainly, lots of pain will be felt, but not nearly as much pain as when it comes time to rip off that duct tape.

Hey congress! Do something sensible, just this once: If you have a bad company that is taking down the financial system, wipe out the shareholders, haircut the bonds, fire the board and CEO, recapitalize, and reboot.

And stop with the third world bailout tactics. It's unbecoming.

Tuesday, September 30, 2008

House of Reps Email Swamped

While trying to send a piece of my mind (a resource in short supply, I assure you) to the House of Representatives, I found that their servers are in meltdown mode today.

The message is clear: Congress can't even be counted on to maintain email for itself. Why on earth would we trust it to bail out Wall Street?

Dude! Where's my meltdown?

I was promised a historic meltdown. Buffett himself promised me one. Where is my historic friggin meltdown?!

With congress rejecting the Paulson bailout plan, the dow dropped by 777 points. We were treated to headlines about "Biggest Point Drop Ever!" Naturally, anybody who has more than a dollar in the market knows that percentage drops are all that matter. A drop 777 points does not make even the top 10 list of all-time point drops; it barely makes the top 20 list at number 18.

Hey congress! Don't you have elections coming up? If I were you, I'd go home and try to get reelected before this legislative fiasco does any more damage to your careers. And stop the fear mongering game. That hasn't been fashionable since Saddam was in power.

Lest I leave you with the wrong idea, I do think that Federal intervention will be necessary to clean up the mess that investment banks have left us with over the past decade. However, the Paulson plan was probably the worst way to approach the problem. Fundamentally, the crisis of confidence stems from the insolvency of the financials. Their balance sheets would have negative net worth if the tsunami of foreclosures were properly discounted, so the Paulson plan did everything it could to prop up the banks with money as well as hide the securities tied to mortgages.

As an investor, why on earth would I return to the market and buy shares in a company that I know was insolvent yesterday, but is solvent today because congress changed the definition of solvency? Furthermore, the companies got themselves into major trouble because of colossal mismanagement of their investments. Having proved themselves to be terrible investors of their own money, why would the Treasury reward them with a $700B investment and think that they have suddenly become great investors?

There is a very straightforward way to deal with these insolvencies. The prescription? The companies should be forced into receivership (the alphabet soup of aid from the Fed is keeping them alive at the moment), then wipe out the shareholders, haircut the bonds, fire the board and CEO, recapitalize, and reboot.

Naturally, the process is painful, but the sooner we get started, the sooner we get back to health.

Finally, I don't agree with everything Ron Paul says, but he delivers a good description of the problem from his testimony yesterday:

Monday, September 29, 2008

Clear, Concise, and a Laugh

Denniger seems to have captured the essence of what folks are trying to communicate to congress here (pdf warning.)

And you might as well watch this video, because you need a laugh while the empire is being destroyed in DC.

Good luck today.

Saturday, September 27, 2008

Politics and the Bailout

The Rasmussen Survey tells us that politicians have not quite made their case to the American public:
Only 30% of U.S. voters think the federal government should step in to rescue the country’s troubled financial markets, according to a new Rasmussen Reports national telephone survey.

A sizable majority (63%), in fact, are worried that the federal government will do too much to respond to the current woes. The survey was taken Wednesday night, even as President Bush was making a nationally televised address urging Congress to pass the $700-billion taxpayer-backed bailout plan proposed by his administration.
This result is similar to anecdotal reports of phone calls and emails into the congressional offices:
Asked about the types of responses he's hearing, Rep. Rush Holt, D-Hopewell Township, said Thursday: "I would say they are 50-50 - between 'no' and 'hell no.'"
So with public sentiment running against Wall Street and an election in 6 weeks, what politician is going to vote for a $700B giveaway to Wall Street?

I think the answer is: Only those no chance of being either reelected or unelected. Currently, only 25 House Republicans (of 199) look set to vote with the Democrats, and I can't get solid figures as to how many House Democrats will vote against.

As near as I can tell, there is a dilemma in front of the folks up for reelection. They would love to vote against the bailout, because that is the clear election-vote winner. On the other hand, if Hank's doomsday scenario unfolds, they don't want to be blamed. They also have advisors telling them that a stock-market crash may happen even if the $700B check is written, which would be the worst result possible for their reelection.

Of those up for reelection, the House Republicans have found their out: They say the current incarnations of the bill simply do not adhere to any principles of the Republican platform, and since the Democrats control the House and Senate, they can vote to stop Armageddon if that is truly what is at stake.

Currently, the best out for the House Democrats is: We will not push through legislation of this size without consensus. It is a weak argument, but seems to be the best one available.

The leadership (Bush, Pelosi, Dodd, Frank) seems hellbent on spending $700B on the way out the door. They have stuck their neck out and decreed, It will pass. Should it fail and the market crashes, they will point fingers at Congress (from the executive branch) or at Republicans (from the Congressional Democrats.)

I have no idea how the current lockup is fixed. Monday will be interesting.

Friday, September 26, 2008

Washington Mutual Reeducates Investors On Failure

There are now all sorts of articles on Washington Mutual's failure. Something that is missing from the discussion is: Why the stock was trading for more than pennies before today. Most folks will point to the SEC regulations that forbid shorting. In a normal market, people who think the bank is insolvent would have shorted WM. So all those folks that bought yesterday would have been saved from the opportunity to lose $1.99/share, because the stock would have already been trading at pennies.

However, I think those regulations are only part of the story. The real question is: Who was still holding the stock?

I can only conclude is that it was mostly held by folks who do not understand the basic capital structure of businesses. The arguments for holding the stock seem to run along the lines of "$1.99 per share?! The furniture is worth more than that!" Now would be a good time to relearn about capital structure, because the common shareholders don't see any of the money from the sale of furniture.

When a company wants to raise money, it has several options. For simplicity, we will look at only bonds, preferred stock, and common stock.

Common stock: An investor puts up money, and will see the promise of share appreciation and/or dividends as the business grows.

Preferred stock: Perhaps the company has already issued common stock and sees a clear business opportunity that requires capital to pursue. They make an offer to investors that they will take money in exchange for preferred stock, which carries a specified dividend, and they guarantee that the investors will get their money before common stockholders if the company fails.

Bonds: The company has some asset (like a building and furniture), and it borrows from a bond investor by offering the asset as collateral. If the company fails, the bond investor sells the asset to recover the debt.

So what happened in the Washington Mutual failure? The banking part of the company was taken over by the FDIC. Since the FDIC is going to take a loss on the banking part of the biz, it sold off the deposits to JPM for $2B. There are other items that need selling.

The remaining part of WaMu (the holding company) will sell off everything that remains, which is not much. The bondholders might see a few pennies, but there are back salaries (for example) to need to be paid first.

After the few pennies go to the bond holders, there is no money left for the preferred stockholders. The common stockholders might as well go out for a beer, because they have no hope of seeing any money from the carcass.

So now the question is: Why are stocks of the remaining troubled banks not at pennies? Will the shareholders learn the lesson from WaMu?

Sunday, September 21, 2008

Goldman, Morgan Convert

From Yahoo -- Last major investment banks change status :
"Investors feared that the last remaining independent investment banks would not be able to survive in their current form. There had been speculation that both institutions would be acquired by commercial banks, whose ability to take deposits would give them a stable source of funding."
What a great idea! Now you too can do your daily banking with the company that lost so much of their investors capital that they BROUGHT DOWN THE BANKING SYSTEM AND NEEDED A TRILLION DOLLAR BAILOUT!

Great idea, people will just run to deposit money in this bank.

Saturday, September 20, 2008

We are rewarding failure

Bloomberg informs us that:
The Treasury is stepping up as the buyer of last resort for mortgage-linked assets that few other financial institutions in the world want to buy.
This statement is absolute rubbish. The problem is that the banks do not want to sell at the current market prices. Some of those prices are, in fact, zero.

The correct response is to sell them out of bankruptcy. Instead, we give them a subsidy by having taxpayers' money buy the toxic waste. We are rewarding failure.

There is only one sensible response from the public: Unelect them all. Vote anti-incumbent this year.

Friday, September 19, 2008

Cox and the Law of Unintended Consequences

So Chris Cox, chair of the SEC, is doing his best to prop up financials. That gives me a warm and fuzzy feeling in my gut.

The only problem: He is freezing out the options market. From Worldwide:
SEC staff will recommend commissioners approve a rule to grant a permanent exemption [to the no-shorting rule], the agency said in statement today. Options market makers would have been prohibited from making short sales starting next week under the ban adopted today to keep speculators from driving down stock prices.

Without the change, the $1.6 trillion U.S. options market may be ``dead in the water,'' said Henry Schwartz, president of Trade Alert LLC. William Brodsky, chief executive officer at the Chicago Board Options Exchange, the largest U.S. options marketplace, called the SEC ban ``draconian.'' The Options Clearing Corp., which processes all trades of exchange-listed contracts in the U.S., said the limit on market makers may prove ``potentially disastrous'' for options, which give investors the right to buy or sell stocks at fixed prices in the future.
As you may have noticed, there was substantially smaller volume in financial stocks today, which is telling us that liquidity is drying up.

So like housing: You can keep the price high, but the number of transactions will drop. In addition, the volatility will also get large and spread in time.

I really hope nobody needs to unwind a large position in this market. The results could be disasterous with these volumes.

Thursday, September 18, 2008

Ban on Shorting Brokerages?

Apparently Chris Cox is considering a ban on shorting, modeled after his market heroes in China where shorting is also not allowed (and has since dropped over 60%). The initial reports from CNBC indicated he was going to ban all shorts, but a Bloomberg article indicates that he's since limited it to just brokerages:
The commission is considering banning short-sales of the shares of Wall Street brokerages after Morgan Stanley fell 39 percent this week, said a person familiar with the matter.
If you've been following this story, CNBC announced originally that it was going to be a ban on ALL shorts. My guess is that Paulson and Bernanke, both well-versed in how markets function, got to Cox and gave him an earful. He now needs a way to save face.

Since shorting adds liquidity to the markets, and liquidity is inversely related to volatility, this ban would be a huge gift to those who bought volatility. It would almost certain crash the stocks involved, since no-bid situations would result during trading hours.

The real question should be: What horrible event is about to unfold that is about to drive stocks through the floor? Is there some new nationalization of companies that is going to kill stocks? We are witnessing history as it is being made, so sit back, relax and pull up a beer. The wild ride continues.

Update: Blog comments are reporting that FDIC folks are in CA to shut someone down tomorrow. Don't know whether they are big or small... Please leave any info here.

Schumer: Inject Money for Equity

Something that seems to have been lost on the market late this afternoon: The comprehensive solution that Chuck Schumer is presenting is going to dilute shareholders of banks. From Bloomberg:
``The Federal Reserve and the Treasury are realizing that we need a more comprehensive solution,'' said Schumer, who today proposed an agency to pump capital into troubled banks. ``I've been talking to them about it,'' Schumer, a Democrat who chairs the congressional Joint Economic Committee, told reporters in Washington today.

Schumer urged forming an agency to inject funds into financial companies in exchange for equity stakes and pledges to rewrite mortgages and make them more affordable.

Schumer advocated a Great Depression-era Reconstruction Finance Corp. model, different from the Resolution Trust Corp.- type plan others have floated.
The last time the gov't took equity stakes? Fannie, Freddie and AIG. This is NOT good for shareholders, they will be similarly wiped out.

Missing the Point

Some folks think they can take two insolvent institutions, combine them, and have a solvent institution. I don't understand why this myth persists; it is easily disprovable with simple arithmetic.

Nevertheless, Wall Street seems to think that mergers will restore confidence. For example, from Bloomberg:
``If we could get some deals done, that will add some confidence to the market,'' said Jack Ablin, who helps manage about $55 billion as chief investment officer of Harris Private Bank in Chicago. `` Banks are as cheap as they've been ever, relative to the rest of the market.''
Lots of folks STILL do not understand the problem. It is not whether things are cheap or expensive, it is whether they have a negative or positive net worth! Until confidence is restored in the balance sheets, there will be no confidence in the banks.

NB bankers: No confidence will be possible with as many Level 3 assets as currently exist. All other efforts will only result in temporary stock pops, because investors will ultimately return to wondering when the Level 3 time bomb explodes.

Tuesday, September 16, 2008

Bailout Nation

CNN has noticed that money is beginning to flow to private enterprise. The lead story as I write this:
"Fed rescues AIG with $85 billion loan:
In an unprecedented move, the Federal Reserve Board is lending as much as $85 billion to rescue crumbling insurance giant AIG, officials said Tuesday evening. In return, the federal government will receive a 79.9 percent stake in the company, reports. Officials decided they had to act lest the nation's largest insurer file bankruptcy."
While it doesn't contain a discussion about moral hazard and the like, it will certainly get the notice of nonfinancial folks.

Random Observation in the wake of the Bailout: I've noticed that several blogs are now calculating how much money the Fed has left, and when it will need its own bailout. Seeing these comments on public blogs is not good for confidence.

Fed Close to Deal to Give A.I.G. $85 Billion Loan

Fed Close to Deal to Give A.I.G. $85 Billion Loan -
In an extraordinary turn, the Federal Reserve was close to a deal Tuesday night to take a nearly 80 percent stake in the troubled giant insurance company, the American International Group, in exchange for an $85 billion loan, according to people briefed on the negotiations.

In return, the Fed will receive warrants, which give it an ownership stake. All of A.I.G.’s assets will be pledged to secure the loan, these people said.
Help me out here: What do the words "Free Market" mean? Why won't every exec of a extremely large company write stupid insurance (I'm looking at you Greenberg) collect the dough, and then let the taxpayers clean it up?

We have truly socialized the losses. Welcome to the ownership society.

Monday, September 15, 2008

AIG Is Tuesday's Headline

So what could be worse after today?

S&P and Moody's have just downgraded AIG. Suddenly they need $75 billion in order to meet collateral calls.

A collateral call is a little like a margin call. When you can potentially owe money on a security, the other party demands that money be held in escrow "just in case". AIG has written several securities that promise to put up collateral in the case of downgrade by major ratings agencies.

I believe the words used on CNBC is a "Financial Atomic Bomb". As CNBC is known for a perpetually sunny outlook on the stock market, things might be rough tomorrow.

If you want to keep track what this does to S&P futures overnight, click here.

Update via CR: NYT is reporting that
But none of those downgrades appeared to lead to events requiring A.I.G. to post billions of dollars of collateral to its swap counterparties. Its swap contracts cite downgrades by Moody’s and Standard & Poor’s of A.I.G.’s long-term senior debt ratings, and such changes had not been announced as of Monday evening.
So the downgrades are not forcing the collateral after all. CNBC says that bankruptcy will happen by tomorrow if not resolved.

This is obviously a developing situation.

Morning Pricing: Merrill and Bank of America

There have been all sorts of bankruptcies, mergers, and fed actions since the last update. Most blogs are All Lehman All The Time, so you will have no problems finding information about last night from them or even from the WSJ.

One observation: Bank of America announced a shotgun marriage with Merrill last night. Both boards approved the all-stock offer, which was 0.8595 BAC shares for each MER share.

As I write this, the implied price of Merrill is supposed to be
0.8595 * 28.62 (current BAC price) = 24.59889

We also note that S&P downgraded Bank of America this morning.

Combining the above factoids tells us that
1. There is considerable doubt in the market that the deal will close.
2. If the deal closes, the net result might be to take down BoA, rather than prop up Merrill.

Update @ 11:35a

Merrill should be 0.8595 * 28.76 = 24.72
and is currently 21.18.

Sunday, September 14, 2008

Insolvency vs Illiquidity

So what is the difference between insolvency and illiquidity? Say you have a credit card, and you owe $1000, all due on the next payment. The payment is overdue. Your car is for sale, and as soon as you sell it you will have the money to pay the $1000 on the credit card.

If the Fed loans you $1000 and puts a lien against your car, they've solved your liquidity crisis. You can take the Fed's money and pay your bill. Once the car sells, the Fed gets its money back.

But now repeat the above exercise and remove the car. That is a solvency crisis. You owe $1000 and have insufficient assets to sell off.

The problem with AIG, Merrill, WaMu, and the former Lehman is not one of liquidity.
It is solvency.

Here's the kicker: You can't loan your way out of a solvency crisis. There is no other means available then to unwind the bad debt. This is exactly what happened with Lehman today. Merrill's day of reckoning was postponed, and will instead happen when Bank of America performs the unwind.

AIG is staring down the barrel this moment. Will they unwind?
Sooner or later, they will.

So in conclusion, we should make the Treasury write 100 times on the blackboard:

Insolvency is not solved by M&A.
Insolvency is not solved by M&A.
Insolvency is not solved by M&A.

Public Service: Click HERE for up-to-the-minute S&P futures overnight.

Just Making Stuff Up

MarketWatch, The Washington Post, and Dealbreaker are reporting various pressures on making a deal happen with Lehman before Asian markets open for Monday trading.

Here's the problem: Major Asian markets are closed on Monday
Japan: Respect-for-the-Aged Day
China: Mid-Autumn Festival
Korea: Harvest Moon Festival
Hong Kong: Mid-Autumn Festival

Just which Asian markets are causing pressure? This tells me that reporters (or their sources) are just making stuff up to sound like they know what is going on.

So maybe a deal happens or maybe it doesn't, but it has very little correlation with the stories that are currently being published in the main stream media.

Subsidizing Barclay's in their Quest for Value

This morning's CNBC is reporting that Barclays is the leading contender to buy Lehman. Apparently, Lehman would sell its good assets to Barclays, and then a consortium of banks would put up $30B to buy the bad part of Lehman.

This deal sounds insane. Why would a bunch of competitive investment banks subsidize Barclays?

If the deal closes, it's not because the financials of the bad bank make it a great opportunity for profit. It's because the consortium have so much rot on their own books that a mark-to-market event would take them all down. So it might be worth billions for them to keep their banks open a while longer and collect their salaries and bonuses.

We'll know by 9am tomorrow.

Saturday, September 13, 2008

Lehman Hires Bankruptcy Firm

The game of brinkmanship continues:
Lehman has hired law firm Weil, Gotshal & Manges LLP to prepare a potential bankruptcy filing, according to a person familiar with the situation. The New York-based Weil has a leading bankruptcy practice and advised Drexel Burnham Lambert on its 1990 bankruptcy filing.

In a Lehman bankruptcy, the firm's brokerage units would have to enter a Chapter 7 liquidation, in which a court-appointed trustee would take over, liquidate the firm's assets and get Lehman customers back their money. In general, securities that a customer holds at a brokerage firm are legally the investor's property and aren't exposed to the claims of the firm's creditors.
A bankruptcy filing on or before Monday would bring an enormous amount of selling pressure to the equity markets. As we said before, strap in cuz it's going to be a wild ride.

Update: Catch the posts over at Calculated Risk, and don't miss the golden words in the comments.

Treasury Wants To Unload Lehman's Real Estate

CNBC reports that the feds wants investment banks to pony up cash and split up Lehman's bad real-estate purchases. However, the idea has gone over like a lead balloon:
On Friday night, after the government finished out what one person with knowledge of the discussion described as the Fed's 'LTCM Plan,' an executive in the room pointedly asked, 'What happens when there's another one?'

People with knowledge of the matter say the government provided no real answer other than to point out what they've been saying for the past three days as Lehman began to implode and look for buyers: There will be no government bailout of the firm, and if the street doesnt do something to help in the process, such as buying Lehman's bad assets, a deal to sell the good part of Lehman will be difficult to complete.
Indeed, what happens when the next one hits?

It is not a question to be taken lightly. If the Feds can't get Lehman sold, then it will be unwound next week. And what would that look like?
If Lehman is not sold, most analysts conclude it will likely be forced to file bankruptcy possibly as early as the end of this weekend. A bankruptcy filing could be catastrophic for the markets, given the size of Lehman's balance sheet. Billions of dollars in trades would effectively be frozen, something that would almost certainly cause massive selling of stocks.

Paulson to I-Banks: Do you really want to do this?

The NYT is reporting that Treasury Secretary Paulson and SEC chief Cox have effectively issued an ultimatum to the NY investment banks: Fix Lehman or we will unwind it.
Timothy F. Geithner, the president of the New York Federal Reserve, called a 6 p.m. meeting so that bank officials could review their financial exposures to Lehman Brothers and work out contingency plans over the possibility that the government would need to orchestrate an orderly liquidation of the firm on Monday, according to people briefed on the meeting.

Flanked by Treasury Secretary Henry M. Paulson Jr. and Christopher Cox, the chairman of the Securities and Exchange Commission, he gathered the executives in person to impress on them the need to work together to resolve the current crisis.

Mr. Geithner told the participants that an industry solution was needed, no matter what, and that it was not about any individual bank, according to two people briefed on the meeting but who did not attend. They said he told them that if the industry failed to solve the problem their individual banks might be next.
An unwinding of Lehman would be catastrophic to many balance sheets throughout the financials industry. It would provide a real-time market quote for many hard-to-value securities. (Currently, many companies are using fictional valuations for these securities, claiming that there is no actual market transaction to use as a reference, so we'll just make something up.)

The real problem: The Goldman's and Morgan's of the world are already short of cash to solve problems like these. So even if they save Lehman, AIG and Merrill are right behind. And since John Thain's statements are catching up with him, it will take more than pretty words to fix companies like Merrill.

Strap in, it's going to be a wild ride on Monday.

UPDATE: The WSJ is reporting that a deal could be announced tonight. Presumably, somebody set an artificial deadline of tonight so that everyone could play a game of brinkmanship and wait until Sunday to come back to the table.

They have also confirmed that it is up to the NY iBanks to prevent a default:
At an emergency meeting Friday night called by the Federal Reserve Bank of New York, New York Fed President Timothy Geithner, described two potential scenarios: either a liquidation of Lehman or an industry-driven solution in which Wall Street firms would possibly providing financing to remove some of Lehman's real estate assets, one person briefed on the matter said.

Wednesday, September 10, 2008

Goldman and Lehman

After Lehman's meltdown yesterday, we get this inspiring quote from Goldman:
"'Goldman is a willing counterparty to Lehman across all our businesses,' spokesman Michael DuVally told Reuters."
What Goldman did not say: We are of course hedging any deal done with Lehman.

I found the statement to be in the category of "Damning with faint praise."

Tuesday, September 9, 2008

Conservatorship Alternative

FHFA is explicit:
Conservatorship does not preclude receivership.

So when the CBO says that "the federal budget is on an unsustainable path", it would be prudent to question whether future administrations will follow through on Hank's bailout vision.

Odds are high that the bondholders will STILL take a haircut in the future.

Monday, September 8, 2008

Hank's Bazooka Is A Boomerang

FRE/FNM bonds are now backed by the Treasury, so the yields of FNM/FRE should converge to those of comparable treasuries. Does anyone really believe that a future McCain or Obama administration are going to see things the way that Hank sees them?

Let's face it: House prices aren't even close to stabilizing. The taxpayer payout on FRE/FNM bonds is going to be substantial.

In future years, when taxpayers are still paying for the nationalization of FRE/FNM, it is going to look VERY attractive to demand that bond holders take, say, a 10% haircut. This move will be a politically expedient method to save an enormous amount of money: On $5 trillion dollars, $500 billion dollars will be generated without raising taxes or cutting spending.

Therefore, the best bet for current investors in FRE/FNM bonds is to sell them and buy treasuries now, while the yields are close. Naturally, since many bond holders will recognize this strategy, the correct tactic is to sell first and not buy any more bonds until the interest rate reflects the risk that future payments are likely to be cut. This will drive the bond rates up, mortgage rates up, and will negate the very thing that Hank is trying to accomplish.

It will be a horrific mess once the markets realize this fact. Fasten your seatbelts.

Friday, September 5, 2008

A Day of Financial Infamy

The NYT is reporting that Fannie and Freddie are going into "Conservatorship", which sounds a lot like temporary nationalization, except that no one in the current administration can own up to nationalizing $5 trillion dollar institutions:
Under a conservatorship, the common and preferred shares of Fannie and Freddie would be reduced to little or nothing, and any losses on mortgages they own or guarantee could be paid by taxpayers.

A conservatorship would operate much like a pre-packaged bankruptcy, similar to what smaller companies use to clean up their books and then emerge with stronger balance sheets.
The Bush administration has officially socialized the losses with this announcement.

We note that the Washington Post claims that the Bush administration is going to protect the preferred shareholders. This will be remembered for a generation or more.

Hank Paulson is Bill Gross' Dog

Let me get this straight:
1. Bill gross threatens to screw the US Treasury unless FNM/FRE are bailed
2. so Hank rolls over
3. The markets go wild, because bailouts are bullish.

Welcome to bizarro world.

Monday, September 1, 2008

KDB to get killer price?

The rumor grows... Is KDB really this stupid?!
UPDATE 1-KDB confirms talks with Lehman on possible deal: "Britain's Sunday Telegraph reported that Lehman had intensified talks with KDB to raise as much as $6 billion in a share sale that could be concluded this week, without specifying sources.

The paper said KDB could buy up to 25 percent of the beleaguered U.S. investment house."
Why on earth would KDB buy 25% for $6B, when the current LEH market cap is $12B? Hell, they can just wait a couple of months and buy it out of bankruptcy with the blessing (and backstop) of the Fed.

Fool Me Twice

A Korean newspaper has been fed information (again!) that KDB is negotiating a Lehman stake: Worldwide: "Korea Development Bank may team with a domestic lender, probably Woori Finance Holdings or Hana Financial Group Inc., to buy a stake in Lehman, Dong-a Ilbo reported today, citing financial officials that it didn't identify.

The state-run bank is in talks with Lehman to buy a stake including management control in the fourth-biggest securities firm in the U.S., the Korean-language newspaper reported, citing the officials at KDB and South Korea's Financial Services Commission. The bank may make a decision by Sept. 10, Dong-a said."
So the old saying goes: Fool me once, shame on you. Fool me twice, shame on me.
How many fools are left to believe this rumor?

Update: Surprise! KDB has no comment on report of Lehman talks

Can somebody tell me why KDB would leak this info and drive the price UP when they are trying to purchase shares? Gimme the proverbial break.

Tuesday, August 26, 2008

Banks In Trouble and the FDIC

Looks like the FDIC is working on a new business plan. Apparently, closing small banks one at a time is inefficient, slow, and probably not adequate given this unofficial list of problem banks. In truth, it is probable that a big bank or two (or three) is being lined up for failure, and Sheila Bair realizes that they don't have the money.

So what will the enterprising FDIC do? Why, borrow money from the treasury, if it gets its way: "Federal Deposit Insurance Corp. Chairman Sheila Bair said Tuesday her agency might have to borrow money from the Treasury Department to see it through an expected wave of bank failures.

Ms. Bair said the borrowing could be needed to cover short-term cash-flow pressures caused by reimbursing depositors immediately after the failure of a bank. The borrowed money would be repaid once the assets of that failed bank are sold.

The last time the FDIC borrowed funds from Treasury came at the tail end of the savings-and-loan crisis in the early 1990s after thousands of banks were shuttered."
The NYT tells us that she is certainly expecting the banking crisis to get worse. They mention that 117 banks are on the troubled list, with assets just under $78 billion.

Do you know that $78B / 117 = $666 million per bank on average? If that isn't an obvious sign of what's to come, I don't know what is.

LEH Rearranges The Furniture

I would love to see LEH sell off their mortgage assets to a new company. It would cause a giant mark-to-market, if the investors were truly arms-length: Worldwide: "Lehman Brothers Holdings Inc. may set up a company funded by outside investors to buy some of its mortgage assets, aiming to dispel concern the firm faces crippling losses, people familiar with the discussions said.

Investors in the new venture would also manage the holdings, which are linked to commercial real estate, the people said, declining to be identified because the proposal hasn't been made public and no decision has been made about how to proceed. The New York-based firm had about $40 billion in commercial-mortgage assets as of May."
My read is that LEH is just about out of options and time. This smells of desperation to me.

Two of my favorite blogs

If you are looking for folks who nailed the housing meltdown well before it was making headlines, then you need to follow thehousingbubbleblog and calculatedrisk. Although there are many good blogs who contributed, these were the two that made it clearest to me that something was amiss.

CalculatedRisk is especially good at spin-free data, like today's Case-Shiller numbers. While a bunch of headlines were trumpeting expectations-beating performance, CR shows the raw data (and the data are not pretty). Even though the number beat expectations by 1.9%, the market seemed to have taken this as a positive.

Frankly, I think that the worst drop in the history of Case-Shiller is terrible news for the solvency of many banks, and beating the expectation by less than the error in the measurement is not cause to run out and buy madly. But that's just me.

As for The Housing Bubble Blog: Ben Jones has a knack for finding regional anecdotes. After reading for a while, you will get a sense of where most of the country is in the meltdown. Ttoday for example:
“Take Holiday. Energized by furious flipping, the median home sales price peaked at $130,000 in early 2006. By the first half of this year, the median price had hunkered down at $75,000. That’s a drop of 42 percent, one of the county’s worst.”

‘It became investor heaven. Now it’s turned into investor hell,’ said Greg Armstrong, president of the West Pasco Board of Realtors. ‘People didn’t want to be left out, but they got burned instead.’
Areas that are not as far along in the meltdown will not have local stories like the above, so it is good information to see what might be coming down the pike.

Monday, August 25, 2008

Dismissing a Rumor

A Korean regulator dismissed dismissed Friday's rumor about he Korean Development Bank buying Lehman.
Korean regulator reportedly warns against buying Lehman: "South Korea's financial regulator on Monday warned the Korean Development Bank should take a cautious approach to buying an overseas bank, following KDB's expression of interest in Lehman Brothers 'In principle, taking over a global investment bank can become an opportunity to raise the capability of the [Korean] investment banking business,' Jun Kwang-woo was quoting as saying by the Financial Times. 'But at the same time, as the risks are also big, KDB should take a cautious approach.'"
Translation: It ain't gonna happen. No how, no way.
So who unwound their position during the rumor pop?

Friday, August 22, 2008

The Law of Unintended Consequences

Freddie and Fannie are now learning the law of unintended consequences. The recent legislation by Congress to backstop these government sponsored enterprises is now interfering with their ability to raise money in the private markets. After all, who would be foolish enough to provide them with more capital when the government now has the right to step in and wipe out stockholders?
Freddie Hunts for Cash -
"But that effort is running up against what may be an insurmountable hurdle: Many investors fear any money they invest now in Freddie or its main rival, Fannie Mae, will be lost later if the U.S. Treasury bails out the companies through a purchase of equity in them. Investors believe such a purchase would likely involve terms that would wipe out the value of previously issued shares."
Moody's saw fit to pile on this morning too:
Moody's cut the firms' preferred stock ratings to Baa3 from A1 and their bank financial strength ratings to D+ from B-.

Thursday, August 21, 2008

Auction Rate Securities Penalties

Strange days in New York state: Their AG has reached a deal with three investment banks for malfeasance in the way ARS were sold:
Merrill, Goldman, Deutsche in deal with regulators: : "New York Attorney General Andrew Cuomo said regulators have reached settlements with Merrill Lynch & Co., Goldman Sachs Group Inc. and Deutsche Bank over their roles in selling risky auction-rate securities to investors.

Under the agreement, Cuomo said, Merrill Lynch will buy back roughly $10 billion to $12 billion of the investments from investors by Jan. 2 and pay a fine of $125 million.

Deutsche Bank, which must buy back about $1 billion of auction-rate securities, has been fined $15 million. Goldman Sachs has $22.5 billion of the securities to buy back, and was fined $1.5 billion.

'This has been a great day of progress,' Cuomo said during a conference call.

Cuomo and other regulators previously reached $42 billion worth of settlements with five major Wall Street banks, including Citigroup Inc. and Switzerland's UBS AG. The attorney general threatened earlier Thursday to sue Merrill Lynch if an agreement was not reached by the end of the day."
DB only pays a penalty of $14M (= wrist slap) for selling $1B of securites, but Goldman pays $1.5B for selling $22.5B of ARS? Remind me: Why does Goldman have a good reputation for negotiation?

Credit Cards Manufacturer Slowdown

In a concrete sign of slower issuance of credit cards: JDSU, who manufacturers the optical films for credit cards blamed its bad quarter in part on reduced orders for coatings.

Tech Trader Daily - Barron’s Online : An Indicator Of Consumer Credit Slump:
"It’s not often a fiber optic company tells you a lot in a direct way about the health of consumer spending. However, I had a fascinating discussion last night with Kevin Kennedy, the CEO of JDSU (JDSU), the $2.4 billion (market cap) maker of lasers and other components used in communications equipment. Part of the company’s business, the “Advanced Optical Division,” consists of coatings used on credit cards. That business, which is 13% of sales, was down about 6% in its fiscal Q4, the company last night reported, contributing to the company missing sales and profit estimates.

Kennedy noted that one of the three largest credit card issuers, a customer of JDSU’s, substantially reduced its issuance of new cards in the June quarter. JDSU has material share in the market for card coatings, so with card delinquencies and charge-offs on the rise, this is yet another meaningful indicator that credit card companies are pulling in their horns, lending less. Just one of the surprising economic tidbits you find from a tech company."

Wednesday, August 20, 2008

Another day, another FRE/FNM bombshell

This morning's Fannie/Freddie fiasco centers on whether the twin monsters will be able to roll over $200B worth of debt. Bloomberg's piece raises (yet again) the spectre of treasury intervention, despite all denials from Paulson et al:
Fannie Mae and Freddie Mac's success in repaying $223 billion of bonds due by the end of the quarter may determine whether they can avoid a federal bailout.

Rising borrowing costs and evidence that demand for their debt was waning last month led Treasury Secretary Henry Paulson to seek the authority to pump unlimited amounts of capital in Fannie and Freddie in an emergency. Their interest costs are again increasing amid concern that credit losses are depleting the capital of the beleaguered mortgage-finance companies.

Rolling over the debt "is the single most important factor to their ability to remain liquid," said Moshe Orenbuch, an analyst at Credit Suisse in New York. "So far, they've been able to do that."

"This whole backstop mechanism was set up so the actual need for it could be avoided," said Mahesh Swaminathan, a mortgage strategist for Credit Suisse in New York. ``The market is testing the Treasury's resolve."

New Capital

The companies, responsible for 42 percent of the U.S. home loan market, need as much as $15 billion each in fresh capital to reserve against losses on mortgages and related securities that they either own or guarantee, Paul Miller, an analyst with Friedman Billings Ramsey & Co. in Arlington, Virginia, said.

The Treasury will probably be forced to buy as much as $30 billion of preferred shares in both Fannie and Freddie by the end of next month, according to Bill Gross, who manages the world's biggest bond fund at Pacific Investment Management Co.
I find it both hilarious and sad that the treasury asked for a blank check while claiming that they had no intention of using it. Perhaps those tactics were required in order to get congress to vote for it while holding their nose.
Initial optimism that Paulson's proposal would bolster confidence in the companies has vanished on concern that the deteriorating housing market may force a bailout, a move that would likely wipe out common shareholders and potentially some preferred stockholders, Miller said.
It's time to face facts: The Paulson plan is only a stopgap to kick the problem into the next administration. Who knows? Maybe he'll still pull it off. However, there was no actual "solution" to the problem: The initial loss of confidence requires more than money, it requires serious housecleaning.

The AP put some color on the upcoming capital raising that needs to occur:
Freddie has said it is committed to raising $5.5 billion to help shore up its troubled balance sheet -- that is nearly twice the size of Freddie's current market capitalization of about $2.84 billion.

Fannie's market capitalization is about $6.58 billion. Friedman, Billings & Ramsey Co. analyst Paul Miller estimates Fannie needs to raise between $5 billion and $10 billion in new capital.

But the prospect of government help has been one of the greatest hang-ups in efforts to raise capital from other investors.

Fannie and Freddie could raise those funds through non-governmental investors, but the cost would likely be severe in terms of interest or dividend payouts depending on the structure of the capital raise and in terms of dilution to current shareholders, analysts said.

"The cost of capital of this nature is just staggering," said Ladenburg Thalmann Inc. analyst Richard Bove. Fannie and Freddie could likely raise capital, but it would cost them so much during the current downturn in the credit market that it is unattractive, Bove said.

At a certain price, though, analysts said the companies would find investors. It is just a matter of what costs and stock dilution investors are willing to incur.
I predict that current investors are going to be unpleased with the results.

Tuesday, August 19, 2008

Large U.S. bank collapsing: report

In the morning news, inflation is raging at the producer level and housing starts continue to tank.

Again, the headlines are hiding some significant developments, one of which is that an Ex-IMF economist sees large U.S. bank collapsing:
: "Kenneth Rogoff, the former chief economist of the International Monetary Fund, reportedly said Tuesday that a large U.S. bank will collapse in the next few months. 'We're not just going to see mid-sized banks go under in the next few months, we're going to see a whopper, we're going to see a big one, one of the big investment banks or big banks,' Rogoff told a conference in Singapore, according to a Reuters report."
It is important that investors abroad keep faith in the American banks, since foreign investment plays such a large role in our current financial system. God help us if that unwinds quickly.

Monday, August 18, 2008

Merrill, Wachovia in Danger of Failing

Most of the headlines this morning are about tough times at Lehman. As a consequence, others are getting lost in the shuffle:
Merrill, Wachovia in Danger of Failing: "The amount of cash written off Merrill Lynch and Wachovia's balance sheets since the onset of the credit crisis still far outweighs the amount of cash they have raised, suggesting the need for fresh capital injections."
As has been mentioned on this blog, John Thain is in definite need of Pinocchio nose-elongation surgery.

Saturday, August 9, 2008

Gone Hiking

It's time for me to trade views of the Rockies for those of my computer.
I'll be back on the 17th.

Friday, August 8, 2008

The Citi Snowball

Looks like the Citi settlement is going to cause a snowballing effect:

UBS to buy back stricken debt securities:
Swiss bank UBS has agreed to buy back $19.4 billion of debt securities whose value collapsed during the global financial crisis, and to pay $150 million in fines to settle charges that it misled investors, a Massachusetts official said on Friday.

Hedge Fund Exit Stampede

One interesting aspect of the current stampede out of hedge funds is the comparison to LTCM (Long-Term Capital Management), which was the first great hedge fund meltdown requiring Fed intervention. LTCM was thought to be large threat to the financial system in 1998, but now it looks like small potatoes:
Greenwich, Connecticut-based LTCM leveraged $2.3 billion of capital into holdings of about $125 billion before its collapse, which roiled financial markets and led to a bailout organized by the Federal Reserve. The company lost $4.6 billion and received a $3.5 billion bailout from 14 lenders in 1998.

July ranks among the worst months of performance for hedge funds. Chicago-based Hedge Fund Research Inc.'s Weighted Composite Index, based on data from more than 2,000 funds, fell 2.4 percent in the month and is down 3.5 percent year-to-date, which would be the worst annual performance since at least 1990.

A mere $125 billion? Pfft. Definitely small potatoes.

Wednesday, August 6, 2008

AIG Bad News, and More Bad News

AIG posted a $5+B dollar 2Q loss yesterday, and that is the bad news.

The "more bad news" is that there's more on the horizon. As one example: AIG listed about $21B of CMBS (Commercial Mortgage-Backed Securities). Of their CMBS investments, 24% were 2007 vintage; 32% were in either New York or California.

The CMBX spread since June 30th, the closing date of AIG's report, has already risen from 750 to 1000 bps. (An increase of the spread implies a decrease in the value of the mortgages.)

That's $21B that didn't even make the article in Bloomberg. Things like their $460B notional value credit default swaps, of which CDO exposure composes $80B, grabbed most of the column space.

However, as the chart above shows: More losses are already baked into the cake.

Tuesday, August 5, 2008

CDO Issuance and Merrill Sale

I spent some time looking at the recent Merrill announcement in detail. Let's combine a few data: First, from a terrific series in the Financial Times

Notice that the bulk of the CDO issuance is 2006 and beyond. Now let's look at the exact phrasing of the Merrill announcement:
On a pro forma basis, this sale will reduce Merrill Lynch’s aggregate U.S. super senior ABS CDO long exposures from $19.9 billion at June 27, 2008, to $8.8 billion, the majority of which comprises older vintage collateral – 2005 and earlier.

1. Only "super senior" tranches were included. "Senior" and lesser tranches are omitted. They might have a trillion dollars in exposure, but we'd never know from this release.

2. The majority of $8.8B of continued exposure (which might be 50.0001%) is pre-2005. If the ratio of the original $20B of exposure was in the ratio of the Financial Times graph, then the part that got sold off was post-2005 by a wide majority.

3. Until there are realistic valuations of Tier 3 items and an elimination of off-balance sheet items, a safe assumption would be to assume that Merrill's 22¢ on the dollar sale (really 5.5¢, since they financed the buyers) is an upper bound for seller-financed deals.

When sellers have highly asymmetric information about an item for sale, intelligent buyers should demand a discount. I cannot think of a better example of this than MER common stock. God only knows what other crap is waiting for recognition on the books.

Monday, August 4, 2008

Credit Card Securitization

It appears that we have a horse race. I would guess that commercial real estate is going to be the next headline-grabbing meltdown, Credit Cards are going to give us a run for the money.

From Bloomberg: Citigroup Posts Loss on Credit-Card Securitizations

"The biggest U.S. credit-card lender lost $176 million in the second quarter packaging card loans into securities, the company said in an Aug. 1 regulatory filing. The New York-based bank completed fewer deals and was forced to mark down its own $9 billion stockpile of the debt instruments and other stakes the company amassed while selling them to investors.

Led by Chief Executive Officer Vikram Pandit, 51, Citigroup manages about $202 billion of credit-card loans worldwide, about $111 billion of which have been turned into securities and sold, according to the filing. Delinquencies on the securitized portion have jumped by 16 percent since the end of last year to $2.16 billion as of June 30, Citigroup said. The firm's results may portend similar losses for rivals.

Banks and other card issuers ``are predicting higher net charge-off rates across the credit-card industry,'' said Meghan Crowe, a Fitch Ratings analyst who tracks credit-card issuers including American Express Co., Capital One Financial Corp. and Advanta Corp. ``Things have been worse than anticipated.''"

Saturday, August 2, 2008

S&P Introduces "Ridiculous" rating

Just when you thought it was safe to back into the water: S&P was fully aware of the
undeserved CDO ratings

In one email message, an S&P analyst called a mortgage or structured finance deal "ridiculous" and wrote "we should not be rating it."

In another email, an S&P manager said ratings agencies were helping to create an "even bigger monster -- the CDO (collateralized debt obligation) market. Let's hope we are all wealthy and retired by the time this house of card falters."

I don't know what S&Ps penalty should be, but it should be large.

As an aside: PR departments throughout the US know that if you have to drop a bomb, do it for the Saturday papers, which has the least readership in the news cycle. If all goes well, somebody else's bomb drops for the Sunday papers, so that everyone forgets your bad news.

Friday, August 1, 2008

Paulson vs Greenspan

I don't know how it's even possible to be an average guy who believes everything he reads. Just yesterday, I was filled with happy economic fervor as Hank Paulson helped us reject pessimism in the economy:

Paulson says housing remains biggest threat

Paulson predicted in a speech to a Washington audience that the economy will continue growing at a moderate pace for the rest of this year, despite housing slump-induced problems.
... Paulson said he expected foreclosures and the level of unsold homes would likely remain "substantially elevated this year and next and home prices are likely to decline further on a national basis."

Nevertheless, he predicted that the bulk of the housing slump would be over in months, instead of years.

Great! We only have a few months until this whole housing-induced economic nightmare is over. So I was whistling among the flowers with Disney birds swirling around my head when this article started raining on my parade:

"'Fannie and Freddie are a major accident waiting to happen,' Greenspan said. He said that they are an 'unstable structure' and should not continue to exist as quasi public/private entities. He suggested that Fannie and Freddie should be nationalized and then broken up into a group of smaller entities, which could be sold back into the market.

Greenspan also said the U.S. is on the brink of recession, and a key factor that could tip the economy is the slowing growth in the world economy. He also made a rather disturbing comment about the current financial crises.

'We've had huge amounts of liquidity engendered by central banks, and it's getting increasingly evident that this is a once-in-a-century type of phenomenon. It is not the standard liquidity crisis we've seen in the past. It's verging on the issue of solvency,' he said."

So on the one hand, I have Paulson telling me this whole mess is going be behind us Real Soon Now, and then Greenspan tells me to go out and nationalize Fannie and Freddie, and implied that the shareholders are going to be zeroed out.

I can only conclude that Greenspan rejected Paulson's rejection of pessimism.

Wednesday, July 30, 2008

Getting Naked

An interesting conversation with a NY friend shed light on the new shorting rules from SEC chair Chris Cox. My friend works for a market maker in research (and does fascinating work, which will be the subject of a future post). Although there has been a lot of noise about "Naked Shorts", he explained that the term is overused. For lack of better terminology, we started talking about the difference between being "Naked" and being merely "Nude".

Being "Naked" was, is, and always will be illegal. It is the creation of shares out of the void, so that the seller fails to deliver within a specified time. The ability to arbitrarily create shares would naturally result in CEOs selling 400% of the total outstanding shares, pocketing 300% of the proceeds while driving the company into bankruptcy, and then fleeing to Tahiti with as naked a trophy wife as the local laws will allow. If you've seen The Producers, you are already familiar with this business plan.

Being "Nude" has always been legal. This shorting comes in two flavors: Locate and Pre-Borrow contracts. The Locate contract is understood to be a short-time borrow of the shares. The shares absolutely can be located upon demand, but a demand is rare because market-makers only need the shares for a grand total of about 10 minutes. Pre-Borrow means that the shares are reserved for 24 hours.

The nature of the recent SEC regulations is that "Locates" are no longer allowed, so that market makers must arrange for Pre-Borrow shares: They must also pay the associated overnight rate, which is substantially higher than borrowing for 10 minutes. Naturally, those who are lending out the shares are quite pleased by the extra fees, but the market makers see it as additional cost and are loudly complaining to anyone who will listen.

The net effect of the rule is that market makers will allow the price to swing by larger amounts in order to make up for the difference. This additional volatility will not cause just greater upswings, but also greater downswings. I doubt that the SEC has fully prepared for the law of unintended consequences.

In summary: Naked is like pornography for Cox, and he knows it when he sees it. So stick to getting Nude, which is far more artful.

Tuesday, July 29, 2008

It's a long hard slog.

Thank god the financial storm is over. At least, that's what the financials seem to be telling us.

If I were looking at a graph of mortgage resets vs time, I might worry that there is more pain in front of us. Let's take a quick look (click on graph for a bigger view):

August '08 is marked by "You are here" on the graph. Strangely, the financial stocks are acting as though most of this has been written down. As of today, about $350B has been written down by financials, which would account for a complete wipeout of the first year of this graph. So why worry?

1. The first year of resets on the graph caused the present damage to housing prices. Resets do not finish until 2012.

2. The agency debt (shown in red) that has caused great distress is increasing substantially in the future. Perhaps the great financial minds have already discounted that increase, or perhaps they have kicked it to a future generation to deal with.

3. Commercial real estate is about to be the next nose dive. Credit cards and autos are on deck.

It's quite doubtful that the financials are done with their pain.

A Merrill Lynching

As recently as July 17th, a mere 12 days ago, John Thain said he was "comfortable" with Merrill's capital position. Yesterday, however, Thain announced that Merrill had diluted the shareholders, invoked a full-rachet provision, and performed a seller-financed transactions of CDOs to the Lone Star Funds. I imagine that his idea of "uncomfortable" involves being on the receiving end of two large Singaporeans named Victor-Tan with some brass knuckles.

There are several conclusions that he put out in the open:

1. Merrill is desperate for cash. They paid a $2.5B penalty to raise $8.6B.

2. Merrill could not sell the CDOs without seller financing, indicating that 22¢ on the dollar is an upper bound on the value of their super-senior AAA CDO debt.

3. He made no comment about marking simliar or inferior debt appropriately. Given his past behavior, we can reasonably assume that there is much on (and off) the balance sheet that has yet to be properly valued.

4. The lack of similar commentary from other CEOs in the financial world on these markdowns means that there is a great deal of pain still to come.

As I write this, the early action in financials is flat. So perhaps some enterprising young hedge fund manager is donating his clients' money to propping up the stocks of financials for a while longer. (Those young hedge fund people are SUCH nice guys.)

Finally, I note that a quick sampling of comments from the morning blogs indicates that there is an angry mob in the wake of Thain's announcement. Is that the sound of sharpening pitchforks?

Update: Great post over at The Big Picture. Here is a summary of Thain's comments to date:

Monday, July 28, 2008

The Big Dilution Begins: MER raising capital

Remember way back in May when Thain said: "This slowdown “won't impact Merrill so much,”?

It turns out that his fingers were crossed, and there is 25% dilution on the way for current shareholders.

Why would anyone believe that he is done diluting shareholder value, especially when he has just demonstrated that he doesn't have even two months visibility into his financials?

Update: The details are even more sordid that I believed at first glance. They are unloading some of their CDOs, but are financing the deal so that they don't completely come off the books:
Merrill Lynch will provide financing to the purchaser for approximately 75% of the purchase price. The recourse on this loan will be limited to the assets of the purchaser. The purchaser will not own any assets other than those sold pursuant to this transaction.

Financials are going to have an interesting day tomorrow.

Second update: Nice list of Thain quotes:

My favorite: Right now we believe that we are in a very comfortable spot in terms of our capital." (July 17, 2008 -- Thain on a conference call after posting Merrill's second-quarter results)

Hurry up and wait.

Reading the headlines over the weekend, you might have thought that the cavalry had just come over the hill to save Fannie Mae and Freddie Mac. As usual however, the devil is in the details. There are several websites that are covering the in's and out's of the new legislation, but there was a small piece in the WSJ that showed the writing on the wall:

Dodd Demands Meeting With Fed, Treasury Officials

The summary is that HUD thinks it will take a year before they implement provisions of the legislation, so Dodd wants to twist their collective arm and apply some urgency to the situation.

Curiously absent from the WSJ article is that Dodd was named as a "Friend of Angelo", which might explain why he considers this particularly urgent.

Friday, July 25, 2008

Bank Failure Friday

Looks like two banks failed on Friday night:

From FDIC: Failed Bank List:
First Heritage Bank, NA, Newport Beach, CA
First National Bank of Nevada, Reno, NV

No word yet on whether these banks were on the FDIC of the "troubled" banks.

Pulling the Pin on the Grenade: 90% RMBS Writedown

Prepare for a special upcoming session of contortion logic from Wall Street investment banks.

The National Australia Bank has acknowledged that over $1B of their mortgage-backed securities have lost 90% of their value. In particular, they are expecting 100% loss on their AAA senior strips and 50% loss on their AAA super-senior strips.

Acknowledging these kinds of losses would be devastating for Wall Street, so naturally this sort of truthful behavior will be attacked.

More about the article can be found here:
Business Spectator - Apocalypse NAB

Thursday, July 24, 2008

Stop Making Sense

Mark Faber is the first person I've seen on a major media outlet that is talking about dismantling Fannie and Freddie.

Just who the hell does he think he is? And how does he propose that we socialize the losses? Is he trying to shut down this blog on it's second day of operation?

But seriously, this video find by Barry Ritholtz at The Big Picture is worth the listen, just to restore your faith that somebody, somewhere has not lost their mind during this fiscal crisis.

Wednesday, July 23, 2008

Bailout Without Hard Numbers

Our fearless leaders expect the mortgage bailout to probably cost $25B. But it might be $0, and it might be $100B. And just to be sure, Congress will raising the debt ceiling by $800B.

From the NYT: A Mortgage Rescue Strains Calculations

The budget office said the chances were better than even that a rescue would not be needed before the end of 2009 and would not cost any money. But the office also said there was a 5 percent chance that the mortgage giants, Fannie Mae and Freddie Mac, could lose $100 billion.