Tuesday, September 30, 2008

Why Main Street should support this rescue

You know its bad when my wife, who under normal circumstances immediately dozes off when I start talking economics, is checking finance blogs looking for news on the credit markets. She is getting into heated arguments with friends over the bail out legislation. And to top it off, she's made a request that I explain to non-finance people why they should support a massive bailout of Wall Street. So here is my case. Hopefully regular readers as well as people far removed from finance will find this stimulating if not convincing.

First let's think about how modern lending works. Pick any type of loan: student loan, car loan, credit card, home mortgage, small business loan, etc. Any time a loan is made, whether its to pay for meal with your credit card or to pay for tuition, someone actually has to come up with the cash to lend to you.

Where do lenders come up with this cash? Primarily three places.

  1. Deposits.
  2. Borrowing from investors or from other banks.
  3. Securitization. This means that the loan isn't held by the lender, but sold to investors.

Lenders don't want to use deposits to make loans right now, because there is serious risk of depositors suddenly demanding their cash. Remember that banks don't ever actually have enough cash to give all their depositors their money on any given day. So when depositors are nervous, banks are nervous.

Normally if too many depositors happened to take money out (not in a panic, but just by happenstance) the bank would simply borrow cash from another bank. That's nearly impossible right now. Banks are generally unwilling to lend to each other. Banks can still borrow from the Federal Reserve, but they are so desperate for cash right now that they are accepting any interest rate, and the Fed is finding it nearly impossible to control short-term interest rates. Today banks took overnight loans from the Fed at 7%, 3 1/2 times the target rate set by the Fed. This is historically unprecedented.

Banks also cannot sell loans to investors. Even loans that are backed by governmental guarantees, like certain student loans, are not sellable in the current environment. Forget about automobile loans or business loans.

So if banks and other lenders cannot get cash, they cannot lend it. So what? Isn't our society doing too much borrowing as it is? Maybe, but let's consider the consequences of a world with no lending.

First of all, there would be no housing market. Very few people can buy a house with cash. Housing prices would continue to fall for many years. The result would be that people would almost universally live in rented housing. Wealthy land lords would own all the housing in America, and would reap all the profits from rentals.

Second, there would be no secondary education. Like housing, the vast majority of people need loans to get a college education. Granted, colleges would probably pare back on the quality of the education offered in an attempt to lower their costs. Even so, it would likely be that only wealthy people could afford college. The income gap in our society would increase as a result.

It would also be extremely difficult for average people to start a new business. Most businesses require start-up capital, most of which is normally borrowed. In addition, many small businesses need working capital, which allows the business to make payroll while waiting for accounts receivable to come in. So here again, only the wealthy would be able to start new businesses.

How will this bailout help? Mostly by creating a outlet for banks to sell "troubled" loans. What constitutes "troubled" isn't yet known. But suffice to say the Treasury will mostly be buying mortgage loans that probably shouldn't have been made in the first place. The price paid to the bank will be less than face value, thus the bank will suffer losses. Hopefully enough of these loans will recover their full value that tax payers do not suffer large losses.

But its a mistake to assume that, as tax payers, we aren't already on the hook for this mess. Currently there is about $8.6 trillion in assets that the FDIC insures. The truth is that the FDIC is ultimately funded by tax payers. So as tax payers, we are already on the hook for bank's behavior. And for way more than $700 billion.

In addition, municipal governments are suffering greatly in this crisis. Not only are their facing the prospect of decreased property tax assessments, but the cost of funding municipal projects has skyrocketed recently. Today, 7-day floating rate municipal bonds are carrying interest rates above 8%, breaking all records. Who will ultimately pay for these extremely high interest rates? Tax payers.

I completely understand the visceral anger that many Americans feel about the situation we're in. I'm sick over the fact that its come to this. But this is what it's come to. We would be foolish, as Americans, to destroy our long-term economic prosperity just to satisfy our righteous anger with Wall Street.

If we don't do this bailout, Main Street will pay anyway, and pay much more dearly. So I would encourage you to write your Representative and tell him or her exactly that. You are angry at Wall Street, but you also want to see some justice for Main Street.

Fell free to e-mail this or send links as you'd like. I don't really care about getting credit.

Wednesday, September 24, 2008

What would ya like?

Does the TARP mark the death of capitalism? To some commentators, apparently it does. To be sure, this kind of massive government intervention is the last thing any real capitalist wants to see. But is what we have now any better? Let's think about why we like capitalism as a concept, then consider whether this market even remotely resembles capitalism.

Free markets are supposed to efficiently allocate resources. If there are too many pizza places in your town, but not enough auto mechanics, the free market is supposed to drive one of the pizza places under and encourage entry by an auto mechanic. While we may feel for the proprietor of the pizza joint, we know that in the long run, we're all better off when the market is allowed to move resources away from the pizza business.

But we don't want to see the pizza guy forced to close shop because of some external dictate. We want to see a vote held to decide whether we have too many pizza shops in town. We want all the pizza places to compete for business, with the better competitors enjoying strong profits. In fact, we don't even want to see the weaker competitors driven under. Ideally, the weaker competitors will improve their operations and become stronger competitors. But if not, then indeed one or more of the pizza restaurants will undoubtedly go under.

So what kind of world are we living in now?

Let's take a hypothetical investment bank. We'll call it Merrill Brothers (MB). MB became involved in underwriting a series of commercial real estate loans during 2006 and 2007. MB retained some subordinate interests in these loans, as management believed these projects were attractive investments.

Some of these were for condo deals, which is obviously not the best place to be now. Perhaps given the benefit of hindsight, MB wouldn't have entered into the condo deals at all. But it is what it is. MB's management needs to decide what to do about the loans now.

I think in a real capitalist economy, MB would be given the chance to live or die based on the actual performance of these loans. Why? When any bank makes a loan, their credit analysis is based on the perceived odds of the loan remaining current. The capitalist system should reward the banks that make good underwriting decisions based on this criteria.

But in today's market, MB would not be given that chance at all. In terms of mark to market, all credit-oriented securities have declined in value from 2007 to today. Obviously a loan for a condo project would have declined significantly in market value. Forget, for a moment, why these loans have declined in market price and/or whether that decline is reasonable. Let's just stick with the fact that the market price is lower than the original price.

Let's assume that MB's management absolutely loves their loan portfolio, but the market believes their loans are only worth $0.60/dollar. And many will question whether $60 is a good price. But if MB plans to simply hold the loan, what does the market price matter anyway? It really shouldn't. MB should have the chance to live and die by the economic reality of their lending decisions. Not the market's perceptions of those decisions.

Now perception becomes reality as the continuous negative headlines cause trading partners and lenders to back away from MB. In the end, MB either fails or runs to some better capitalized partner. But ultimately it isn't a capitalist ending at all.

Think of it like a poker hand. There are two queens and a 10 on the board, and you have a 10 in your hand. Your opponent is betting the hell out of it. Sure seems like he's got a third queen, and maybe the best play is to fold. But should the other players at the table step in and force you to fold? In a free market, you can bet, raise, or fold, no matter what other people say.

So now we're faced with to non-capitalist paths. On one hand, the current situation. On the other hand, a government bailout.

The bailout will create some semblance of confidence in financial institutions and their balance sheets. There will be some increase in lending capacity. There will be some end in sight for declining home prices.

If there is no bailout, then what? When do things improve? Does the commercial paper market shut down? Is it possible to leverage trading books? Can anything be securitized?

So as much as we all hate the idea of a government bailout, we really need to consider what kind of capitalism we think we're defending. I'd love to hear more about long-term solutions to our problems. But in the short-term, we have to stem the relentless waves of fear. Before its too late.

Monday, September 22, 2008

Stock shorting isn't the problem. CDS are.

There has been much hubbub over the SEC's new naked short-selling rules. Now, I've got no problem with enforcing some basic short-selling rules, but it won't make a difference until something changes in the credit-default swap (CDS) market.

Let's stipulate that speculation and manipulation is part of the problem here. Let's stipulate that John Mack is right and that if Morgan Stanley were to go down, it would be solely because of short-selling.

To make that claim, you have to assume that pressure from short-sellers is feeding upon itself. That Morgan's falling stock price is creating panic, bringing out more sellers and causing more panic. But if you really want to create panic, the CDS market is a better choice. In stocks, you can always offer a stock below the current price, and that may spook people. But the CDS market is traded over the counter. The trading volumes are unknown. Bid and offer sizes are unknown. In such an environment, anyone can throw any bid or offer out there and move the market.

In addition, buyers and sellers need to be matched in this market. In a time when there are few sellers of protection (the seller is effectively long a credit), eager buyers of protection can move the CDS market wider extremely rapidly. The general lack of knowledge about the CDS market doesn't help either. Media reports suggesting that a particular "expected" default rate is predicted by a certain CDS trading level shows a complete misunderstanding of the CDS market.

What could be done? The first step would be to move CDS trading to an exchange. This would allow for more disclosure and less mystery. It would also reduce all the country-party confusion that has surrounded AIG and Lehman and eliminate the need for novation.

Second, make the CDS contracts more standardized. Currently many CDS players don't actually close out their contracts, but rather buy off setting contracts. As a result, any given contract becomes less liquid than it really should be, which makes price discovery all the more difficult.

Another step would be for market makers in CDS to increase the margin requirements on CDS trades. Margin requirements on CDS are set by individual investment banks, but there is no reason why there couldn't be a coordinated effort on this. Increasing collateral requirements would force protection buyers to be more judicious about which names they short. By the way, having an exchange would make monitoring collateral requirements much easier.

There may be other solutions to the CDS problem, some of which will take time. But the steps I've outlined could get done quickly. And they need to be.

Friday, September 19, 2008

Resolution? Trust? A Jedi seeks not these things!

I hate to say it. But we need this. There needs to be massive government intervention to create some degree of confidence. It would be one thing if Lehman and Merrill and WaMu and AIG all went under (or were taken out under duress). But now they are coming for Morgan Stanley and Goldman Sachs.

That just can't happen.

Look, the financial world is a confidence game. Even simple trades involves confidence. You put your money into a Merrill Lynch account and buy a stock, you assume they're holding that stock. Hell, you assume the money market fund they use is safe. You assume your bank will be able to cash your checks. Etc. Etc.

Once that confidence is lost, the system can't continue. Everything will break down, and I mean everything. Our whole economic system would collapse.

Spare me the moral hazard arguement. What about the reverse? Should Goldman Sachs pay for the sins of Bear Stearns? Should Morgan Stanley pay for the sins of Lehman Brothers? Look maybe no one is completely innocent here, but it seems to me that Morgan Stanley is petty theft whereas Bear Stearns was a serial killer. Should we execute both?

Its sad that its come to this. But I don't know what else we were supposed to do. I want to live in a Libertarian/Capitalist paradise as much as anyone. But if we waited for the market to figure all this out, we'd be left with no capacity to finance anything. Our economy just won't work like that. No capitalist economy could. Its called capitalist for a reason. We need capital to make it work.

Bonds are highly illiquid right now. Even Treasuries are showing unusual bid/ask spreads. There are many many many players who are going to be caught on the wrong side of this thing. On top of that, there are many players who are going to (quite reasonably) want to flatten their positions and wait to see how this plays out.

In corporates, especially Goldman and Morgan, potential sellers have disapeared so as far as I can tell, little is trading currently. CDS are gapping tighter of course. There will be a serious short-squeeze in CDS before things stabilize.

Some hedge funds are going to get crushed. I mean, anyone who was leveraged short financials may wind up getting busted out. That will result in some weird trading in seemingly unrelated instruments. Hence, I think you would be wise to not chase this move too aggressively. If you can find stuff that's lagging merely because it isn't getting any attention, fine. But don't over play it.

Personally (not professionally) I'm looking to reset a dollar short I've had. While this may be the right move for the economy, it isn't good for our currency.

Monday, September 15, 2008

Lehman Brothers: Bounce too close to a supernova

I have nothing to say about Lehman itself, except to say that I really and truly believe they could have remained solvent in a more normal market. I'll also say I'm surprised no deal emerged as it seemed to me like there were enough parts worth buying. But deep down, I think Barclays in particular was scared that if they bought "Lehman" assets, the market would have seen it as nothing more than "Lehman" assets. In other words, Barclays might have gotten away with buying the same assets from someone else, but the very fact that they were Lehman's would create a special stain. What would then stop them from coming for Barclays? Ultimately, it was too risky.

On the market overall, it should be lower. Goldman and Morgan Stanley are going to have to merge with a bank. Period. Even if its a bank that's smaller (say a U.S. Bank), it will have to be done to diversify their funding sources.

This also pushes back any kind of recovery for the economy for a long time. I was thinking 3Q 2009, but now I'm thinking at least a year beyond that. I could be convinced to move off that either way by incoming delinquency figures, but for now I'm thinking year-end 2010 before any improvement in the economy.

So I've further reduced my credit underweight and increased Treasury exposure. The risk on Treasuries is the dollar. Most of the Treasury rally in September was dollar related up to today. For the moment we're getting a big rally on fear, which makes sense. But if the dollar starts to get pushed around, the Treasury market won't hold up.

Right now I'm willing to bet on Treasuries because I don't think Europe is any better off, and in fact I'd expect interest rate differentials to favor the U.S. on the margins (i.e., Europe will cut rates). But the situation is fluid enough to where I'm watching everything very closely.

This is truly uncharted territory.

Wednesday, September 10, 2008

Fannie Mae's new Debt: Look at the size of that thing!

Fannie Mae sold $7 billion 2-year notes this morning at Treasuries +70. The deal was oversubscribed. Here are the distribution stats.

US: 63%
Asia: 12%
Europe: 8%
Other: 17%

By type...

54% Money managers
27% Central banks (!!)
19% Other

The 27% Central Bank number is really helping Agency spreads tighten. We're 5-6 tighter, with MBS mildly tighter as well.

Dunno what to say about Lehman. Seems obvious that Fuld has given up the quest to remain independent and is looking for a buyer. That's why they are doing this spin-off of commercial real estate. Once they do the spin-off, then they are basically just a bunch of investment bankers without all the balance sheet ugliness.

Some are skeptical that finding a buyer is possible, but all Lehman needs is someone who has a stronger balance sheet and can take reasonable risks, and the firm can be plenty profitable. It will probably be someone who wants to rapidly increase their presence in the U.S. HSBC has been mentioned, but denied interest. Or Nomura. Either way, someone like that should have interest in Lehman at some price. Remember, it will only take about $4 billion to buy Lehman at current market prices once you take out the commercial real estate holdings.

I'd rather buy Lehman than WaMu. There was a time when several banks were interested in WaMu, but bear in mind that WaMu's whole business is West Coast banking. Maybe J.P. Morgan would still be interested at some price, but you have to wonder JPM wouldn't rather hunt for another West Coast bank with fewer problems. There are accounting issues, which the media has been talking about all day, but forget all that. Do you really think buyers are saying "I'd love to own WaMu, but the accounting is tough." No, I think they are thinking, "I'm not really interested in WaMu, and I'll tell the media its because of accounting."

MBS: Marching into the detention area

While many expected the Treasury to eventually act on the GSEs, few (including myself) expected it to happen over the weekend. So what's the trade in fixed income? There have been four major ideas bandied about Wall Street over the weekend. They are: buy agency debentures, buy agency MBS (mortgage-backed securities), buy credit, and sell Treasuries.

The one I like the most is buy MBS. Yesterday MBS spreads moved dramatically tighter, 55bps in OAS (option-adjusted spread) according to the Lehman index, from +147 to +94. But you haven't missed it yet. For most of the last 10-years, the index OAS has been between 30 and 60bps, so there is plenty of room to tighter further in OAS. I've always felt as though OAS was an over-rated value metric, but today its especially questionable. The Treasury has announced their intentions to buy MBS in the open market, with the clear goal of pushing mortgage borrowing rates lower. Ideally the Treasury would like to set off a refi wave, which would help banks "naturally" delever as well as help separate good loans from bad. In order to get most 2006-2007 borrowers "in the money", mortgage rates probably have to fall to around 5.25%. I think this implies another 50bps of MBS tightening.

Buying agency debentures is less intriguing. Right now non-callable agencies are trading between 50 and 60bps more than comparable Treasury bonds. This spread might fall into the 20's for short-term bonds, but it won't collapse to zero. We don't currently know what the GSEs will look like after 2009, and therefore bonds maturing beyond 2-years shouldn't (and won't) be viewed as truly government-guaranteed.

Credit is highly questionable here. The large-cap financials should benefit significantly from a mortgage refi-wave. This would get the "good" loans off bank's balance sheets, freeing up capital, and clarifying how much each bank truly has in good versus bad loans. But the real catalyst for finance credit will be bank earnings which isn't until next month. Obviously the Lehman situation isn't helping either. Buying new issue bank credits isn't a bad idea as a trade but I'm staying underweight for now.

Non-finance credit makes even less sense. The GSE bailout may have been necessary, but it isn't a panacea for the real economy problems we're facing. I'd stay very high quality within credit.

The direction of Treasury rates is also questionable. There remains significant dollar-related buying, as evidenced by the strong bid for the 10 and 30-year bonds in recent sessions. That is a classic sign of foreign bank buyers, especially given the fact that economically, the yield curve should probably be steeper not flatter. There is also no particular reason to believe the GSE bailout results in dramatically more Treasury supply. Not to mention the simple fact that the economy remains weak which should be a natural support for interest rates. I'm staying close to home on duration.

Friday, September 05, 2008


Remeber like 4 hours ago when I said it didn't look like anything was going to happen with Fannie and Freddie? Yeah... what I meant to say is that something could happen this weekend! At least that's what the Wall Street Journal is reporting.

Anyway, we'll see what it looks like. I still think that its most likely that the companies have agreed to whatever the Treasury is about to do, so it can't wipe out shareholders. Some capitalist president this dude turned out to be...

Unfortunately, the effect is going to be Treasury rates selling off and MBS rising, which isn't how I'm set up.

Did you catch Bill Gross on CNBC just now? They asked if he had been approached by the Treasury about any government-led solution, presumably asking if PIMCO would participate. Gross said he couldn't comment, which means the answer is yes. Hmm... wonder why no one asked Accrued Interest!?!

Anyway, its possible that this turns out to be a rotation moment, because a bailout of Fannie and Freddie doesn't solve our real economy. It does help prevent it from getting worse, but it doesn't solve anything. But it should help bring mortgage rates down, creating liquidity for financial firms. Could also improve risk aversion, which would help financial firms raise capital or at least sell debt. So we could see a period where financials outperform industrials.

GSE Bailout: Episode III

In recent weeks, a GSE bailout has seemed less imminent. Not because anything is getting better, but because it appears that the Treasury lacks the will to make a move. To be fair, the way the authorizing legislation is written, the Treasury cannot make a move without either the GSEs falling below their capital minimums or compliance by the companies. Based solely on how the company's are valuing their assets and liabilities, their capital position is well above regulatory minimums (especially Fannie Mae).

Now many believe that F&F's asset values are inflated, and perhaps that's true. But what do we expect? Will the government come in and audit the companies, write down their assets and then nationalize? It seems far fetched.

So if there is going to be some near-term action on strengthening the GSEs, it will have to come in a form to which the companies would consent. Ergo, it can't be something that would punish common shareholders.

I think that leaves three options. First would be to do nothing and see how things develop. Let's get back to that one later. Second would be for the Treasury to start buying loans and/or securities from the GSEs to reduce their liabilities. I talked about how this could work here.

Third would be for the Treasury to help the GSEs raise private capital. What if the Treasury agreed to guaranty the principal (not the interest) on a preferred stock offering. The size would be whatever is determined to be needed. In reality it might not be a single preferred offering, but a series of offerings with some pre-determined limit as to the total size.

The preferreds would be callable after 5 years, with the call becoming automatic if the GSEs share price reaches some milestone. The idea would be that if the GSEs are able to issue common equity, then they would be forced to call the tax-payer backed preferred and issue their own securities of some variety.

The Treasury could charge some fee in exchange for the guaranty. Say its an interest rate equal to the 30-year Treasury bond rate, currently about 4.25%. What interest rate the preferred would carry to investors would be determined in the market, but I'd bet somewhere in the 6-7% area.

Here are the advantages of such a plan. First, it could be implemented right away, allowing for stability in the mortgage market and likely a decline in mortgage lending rates. Second, its probably a cheaper plan for tax payers when compared with other options. We know that F&F's new business will be profitable, so if they can be stabilized with a capital injection, the odds that tax payers actually have to shell out any cash is low.

Unfortunately, this kind of solution has a number of problems. First, it creates all kinds of moral hazard, as common equity holders wind up benefiting from the tax payers risk. Currently Fannie Mae and Freddie Mac preferreds are trading with 15% yields, and a new issue, if possible at all, would certainly come at a discount to current levels. So under this plan, the GSEs would be able to issue preferred equity about 500bps cheaper than would otherwise be.

Second, this plan doesn't move us any closer to a more permanent solution to the problem of macro risk and the GSEs. Its a plan that, while easy, doesn't really get us anywhere in the long-term. I suppose such a plan could be an interim step on the path toward full privatization, the idea being to stabilize the market now, buying time for a long-term solution.

Its looking to me like this administration won't do anything about Fannie Mae and Freddie Mac unless they are truly forced to do so. The closer we get to a new administration, the more likely that Paulson waits and lets the next Treasury secretary make the call on the GSEs. So I think we're in for another 6-months of the same with the GSEs. Its always possible that something happens in the interim that diminishes risk aversion and subsequently allows the GSEs to raise capital privately, but I'm not optimistic.

Would I buy agency securities given this outlook? Yes. Senior debt and MBS, but I remain underweight both. I'm probably negatively exposed should a full-on bailout occur. But that's a risk I'm willing to take.