Monday, October 22, 2007

I wonder if your feelings on this matter are clear

Interesting last few trading days to say the least. First we had several banks report ugly earnings: Citigroup, Bank of America, J.P. Morgan, Wachovia, Wells Fargo, Washington Mutual, among others. Bank stocks are getting hit pretty hard. Since Citi is down over 24% YTD, Bank of America down 11% while the S&P is up about 7.5%. Both banks are down more than 7% since 10/15, when the MLEC plan was unveiled. The bank earnings seemed like non-news to me, at least in terms of the big picture. After all, what did we learn?

  • Most complained that the liquidity crunch had harmed their results.
  • Those involved in bridge loans took write downs.
  • Most rose their loan loss provisions related to consumer loans.
  • Their collective view of the housing market was poor.

None of this seems like new news to me. Plus we all know that when a public company is having a bad quarter, they usually go ahead and cram all the bad news into that quarter, so that subsequent quarters can look all that much better. And yet the market has taken it on the chin, both in credit and in stocks. And all the jobs report-driven euphoria of just two weeks ago has completely vanished.

Here are my takes. First, bank losses in sub-prime don't really worry me from a credit perspective. I think its relatively easy to get to the bottom on how much in sub-prime a bank has, and then you can make a reasonable judgment about how big a loss that might turn out to be. All of the large banks I mentioned above, yes even Washington Mutual, don't have enough direct sub-prime losses to add up to insolvency. And banks have a hell of a lot more access to liquidity, if for no other reason than the discount window, than straight finance companies like Countrywide or dare I say New Century. If all you care about is survival, big banks are still a good bet. The stocks are a harder call, because stock investors need growth of profits and these banks are going to be more balance sheet focused over the next several quarters and less income statement focused. I can't really say at what prices the banks are a good buy, because I don't follow them closely enough to say at what price zero profit growth is priced into the stock.

However, the SIV problem is potentially a space-station sized issue. Citi is the headliner here, but even their supposedly $80 billion in SIV sponsorship can't possibly amount to insolvency. However, something is amiss. The MLEC idea seems like a solution to a non-existent problem, and doesn't seem to solve any actual problems. Just makes me wonder what the banks know that we don't know. I'm beginning to suspect that we're digging in the wrong place by looking at losses within the SIVs. Maybe the real problem is with bank money market funds. Banks don't want to ever ever ever break the buck. Remember, most banking services are commodities to consumers. If consumers lose even a small amount on their money market fund, the bank can kiss that relationship good bye. And yet, banks legally have a hard time making up for losses within a money market fund out of their own pocket. Has to do with recourse. Anyway, maybe the MLEC is designed to prevent defaults on CP held by bank money markets, in essence by passing the risk on from the money market fund to the bank itself. Its so crazy it just might work!

Disclosure: I own bonds for Washington Mutual and Wachovia through client portfolios.

17 comments:

Anonymous said...

I think you answer your own question. The banks are down because the outlook for earnings growth going forward (the next 4 quarters) is much worse than just 1 quarter ago and could continue to worsen and investors dont trust their disclosure.

F-Trader said...
This comment has been removed by the author.
James I. Hymas said...

National Bank of Canada avoided breaking the buck in their Altamira funds by buying the ABCP the MMFs held at purchase-price-plus-interest.

They also repurchased some ABCP sold to their retail clients.

I thought it was irresponsible, myself. It is not clear what the (Bank) regulators think ... Sections 790-794 of the Draft Guideline for capital adequacy take rather a dim view of such goings-on.

RW said...

Protecting money market funds and making balance sheets look a little better were the only really plausible reasons I could think of for M-LEC myself. Otherwise it was just a book rearrangement, or one of deck chairs for those fond of more dire metaphors.

Accrued Interest said...

Money market funds as products are funny in a lot of ways. I'd say that banks/brokerages/investment firms view their money market primarily as a service for which they charge a (very) small fee. In fact, I know of at least one bank who has a no fee money market offered to very large customers.

Anyway, if a bank is thinking of their money market as a service, then they'd gladly refund customers any small losses they take, similar to how they'd refund you if they had accidentally cashed a check of yours improperly. Check cashing is a service, money markets are a service, and they want to keep you as customers either way.

But of course, they can't have it where there is recourse to the bank, because then regulators would view the money market assets as part of the bank's risk.

Accrued Interest said...

If you read James's post on his blog...

http://www.prefblog.com/?p=1343

I think his explanation is reasonable, but as RW says, to what end for the banks? I mean, the structure JH proposes makes total sense from the MLEC's point of view, but why the hell would the banks bother creating it? How much better off are they over absorbing the SIV onto their balance sheet? I might be wrong about their intentions, but its confounding me for the moment.

Of course, maybe Paulson has a political goal of doing something dramatic but with no real substance. Wouldn't surprise me.

James I. Hymas said...

If they take it on to their balance sheets, it will go into risk-weighted assets at 100%, vs. 10% for a liquidity-backstop only.
I imagine capital ratios have lately been getting much more scrutiny in the CEOs' offices than previously!

Why not use other people's money for the financing, as long as you retain the capital note?

From Treasury's perspective, it also keeps the asset class alive for future expansion. You want a rock-solid banking system, sure, but you also want some non-bank players doing analysis-intensive stuff around the edges to keep them honest.

Anonymous said...

WB took a $40MM hit buying back CP from their Evergreen MMKT funds.

Dave M. said...

SSYPX, an ultra short-term bond fund, (alternative to MM funds)is down 10%, which might give clues to the value of short term paper. Yes/ No?

Anonymous said...

Superb post, Accrued Interest. Keep them coming!

gramps said...

Accrued Interest hit the nail on the head with his first guess: the MLEC is just a fancy mega-SIV designed to take paper the banks are going to be stuck with anyway -- but it allows them to pretend like it is not on their balance sheets.

As Hymas points out, this allows them to take a smaller *accounting* hit, even though the economic hit will be just as severe as if they just took the bad debt onto their books.

I am not sure if I agree with Accrued Interest about all this stuff (ABCP + bridge loans + subprime) not causing insolvency; I would be surprised if at least one major bank doesnt bite it when all the dust has settled.

A bigger issue (see Japan for illustration) is that most banks are going to have their balance sheets locked up with bad loans for quite some time. You don't need a bank to fail outright-- if its Tier 1 capital falls low enough (Citi?), they will not be able to trade swaps and access international markets at the same price as competitors. Money velocity at these banks collapses -- effectively it amounts to forced deleveraging at not so advantageous prices.

And another 800 pound gorilla in the room is that many banks (Citi, BofA, Wachovia to name a few) have "made money" at least from an accounting standpoint, through loads of M&A. Maybe you think this or that isolated asset was undervalued (unlikely IMHO after years of bull markets) -- but system wide, two plus two cannot equal five unless dubious accounting is used.

Every other time banks went bananas with stupid lending (think Latin America debt, PennSquare bank, etc) -- a major bank either defacto failed (Citi after Latin America) or did fail (Continental Illinois)-- and lets not forget how all those REFCO bonds came to be.

As the saying goes, this time will *NOT* be different

James I. Hymas said...

As Hymas points out, this allows them to take a smaller *accounting* hit, even though the economic hit will be just as severe as if they just took the bad debt onto their books.

Not quite. It is my understanding that the intention is to pay for the assets with a mix of cash (obtained from the sale of senior notes; it could even be senior notes in lieu of cash) and mezzanine notes. In such a case their contractual exposure to losses will be limited to the value of their equity tranche, although implied support, if effected, could take their actual exposure up to any number you like, including 100%.

It is also my understanding that SuperConduit will not be purchasing "bad debt" per se; the intention is to buy un-financable and un-marketable debt.

Anonymous said...

I think the banks may have further troubles ahead. Business week reviews their hedge fund fiasco in Bear bets wrong:

http://www.smalllinks.com/2HF

I know for a fact Bear Sterns is quietly trying to offload equity tranches of CLO's they own on their books. As the business week article notes, the banks value these assets how they see fit (as there are no real markets to effectively price this stuff with).

One of two things could happen:

1. there is a mad scramble to get the stuff off the books prior to year end (read deep discounts and write downs), or,

2. The auditors come in and write the stuff off for them and there are large capital calls (read "banking mergers")

The tide is just starting to go out and there's more to come.

gramps said...

Hymas- the implied support is 100%... there isn't much purpose to the MLEC if the banks won't stand behind it.

Ford and GM like to say that their ABS are not liabilities, and represent a "true sale" in the legal sense. But the fact is their business model depends on continuously selling more loans. If they allow the ABS to fail, they kill their own business model. It is legally off balance sheet, but economically it is their liability.

Same thing for finance companies that underwrite debt (MBS, CDO, ABS, whatever

John said...

Thanks all for the high level of discussion, which is extremely helpful to this reader. May I confirm something? I understand that banks would not be liable for SIV losses in the ordinary course - that is, absent some fraud or other veil-piercing theory. Is that right? I understand gramps' point about the reputational/business model effect - which makes a lot of sense - but my question is directed specifically to legal liability. Many thanks in advance.

Accrued Interest said...

John:

Generally yes, although in many cases the bank put a guarantee on the CP of the SIV. But a lot of SIVs (especially the ones in trouble) are non-bank vehicles, particularly hedge funds.

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