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.