Tuesday, March 31, 2009

PPIP: Maybe you'd like it back in your cell?

The big question surrounding the toxic asset plan is will banks sell? I've put a little pencil to paper here and come up with some actual numbers.

First of all, I expect the Legacy Securities Program will work wonderfully. Sellers will flock to it like Jawas to a stray astromech droid. This program is aimed at securities which have been severely impaired from both a credit and liquidity perspective. CLOs, RMBS, ABS, CMBS, etc. The program should succeed in turning these programs into just credit impaired. In effect, it will separate the red ones with the bad motivators from the blue ones in prime condition. That will be key to an eventual economic recovery. It should foster a healthy new issue market for RMBS, ABS and CMBS (don't know that CLOs can come back), which will help get the velocity of money back to a more normal level.

Obviously having ready buyers able to earn impressive ROEs should improve the value of the underlying assets. Financial institutions have already marked these securities to market, an improvement in the actual value of the instruments ought to result in an improvement of balance sheets. This will particularly benefit financials who invested primarily at the top of the asset-backed capital structure. It will also benefit those that hold more risk in securities (such as brokerages Goldman Sachs and Morgan Stanley and possibly some P&C insurers) and less those that hold risk in loans (such as almost all banks). Even there, much of Goldman and Morgan's risks are tied to the equity markets, not to debt markets. Same goes for life insurance, generally speaking.

That brings us to the with the Treasury's Legacy Loan Program. I expect this to go over like the exotic twi'lek dancer's routine in Jabba's palace. The plan will indeed increase the theoretical price at which banks could sell loans. That's fine, but its short help. Loans haven't been marked to market. Instead, they are held at book value less an allowance for expected loss.

I've done some deep dives on bank residential loan portfolios. Getting detailed data is a challenge, but basically I tried to figure out what percentage of the bank's current portfolio is "challenged." High CLTV, bad geographics, low FICO, etc. You can make a relatively safe assumption that most of the loss reserve is pledged to those kinds of loans. Anyway, I can't find any big banks that are holding, say home equity loans at less than 90% of face. Unless the Legacy Loan Program winds up buying assets at $90 or more, banks won't sell.

So will the PPIF's pay $90? I doubt it. Take home equity loans as an example. Start with the following assumptions:

  • PPIFs get loans at 1mo-LIBOR +50bps. Its hard to say exactly what the cost of funds might be, but worth noting that FDIC paper trades around L+20.
  • 6-1 leverage, which is the max allowed under the program. I think its reasonable that non-delinquent, prime loans would get the max leverage.
  • Assume the loans float at Prime-flat.
  • Assume the loans are 1-2 years old, and will repay over the course of 6 years. To make it easy I'm going to assume equal payments per month.
  • The pool of loans will suffer 10% cumulative losses, all of which occur in the first two years. I won't write down the losses as they occur, simply take away the interest. That's consistent with a hold-to-maturity IRR calculation.
  • Finally, and perhaps most importantly, I'm assuming that the PPIF equity investors are targeting an IRR of 20%.
The result? $82.5.

That price will render it impossible for most banks to sell. For example, based on Bank of America's recent earnings presentation, it has something like $250 billion of prime, non-delinquent home equity loans with 90%+ LTV. I'd call this the kind of stuff that isn't exactly toxic, but selling could improve BAC's risk exposure significantly. Say they effectively have a $90 mark on these. If they sell at $82, they'd suffer an 8% loss versus their capital, or $20 billion. BAC has core equity capital of $48 billion. You do the math.

I don't expect commercial loans to be much better. Now a lot of commercial stuff has large loan loss reserves, and therefore sales would more easily be accretive to capital. But commercial loans are also present an information asymmetry problem. You can put a zillion residential loans into a pool and get some semblance of diversification. You can then look at average stats and get some idea of the make-up of the loans: geo diversification, average FICO, etc. A bank that is selling a commercial loan is telling you they don't want that commercial loan anymore.

This isn't to say the toxic asset plan will have no positive impact, but it is likely to be more indirect than investors are currently hoping. The best chance banks have for decreasing their residential loan portfolios is a revived securitization market, which is the primary aim of the TALF. Banks may be more willing to sell a portion of their home equity loans as a senior security, with the bank retaining a subordinate position. In that case, the bank might retain the upside while still freeing up some capital. In addition, a revived securitization market would give the market confidence that banks have enough liquidity to hold their loan portfolios to maturity.

It will also help banks who have made larger writedowns, especially those that made acquisitions. At the time of acquisition, the bank has to write down the loan to fair market value. In the case of J.P. Morgan's acquisition of WaMu, or Wells Fargo's acquisition of Wachovia, there would be no motivation to under-estimate the FMV decline. Those banks could therefore enjoy improved capital positions from certain sales.

Friday, March 20, 2009

Simon Property: No coupon is worth this

So most mornings I come into my office about 7:15. We bond people need to get up early you know. Anyway, first thing I do is fire up my Bloomberg and check my messages. The New York traders are all in even earlier than me, so usually I already have a fairly long list.

The early messages are mostly corporate bond runs, that is where various traders estimate where the bid and ask is for certain large issue corporate bonds. Around 8AM, I start getting announcements of new corporate bond issues.

This morning there was an unusually early message indicating a new issue announcement. And it was a dozy. Simon Property Group. Now admittedly, SPG is clearly a market leader among REITs, but still, its a REIT. In this market, from a bond holder's perspective, no sector is more dicey than REITs. Even banks you can point to substantial government support. With REITs there isn't likely to be any safety net at all.

Now I hadn't yet heard about SPG's simultaneous equity offering, but regardless. I replied to the salesman with the following loquacious e-mail.


I mean, activity in corporate bonds has improved from where we were in October to be sure, but Simon Property? Most of the recent corporate bond issues have been very high quality, or at least in less cyclical industries.

So I'm thinking to myself, what the hell kind of level does Simon have to pay to do a $500 million 10-year unsecured bond issue? 11% is what I was told.

Corporate bond traders talk about something called the "new issue concession." This is the differential between existing bond levels and the level at which a new deal needs to be priced. For example, Sysco (the foods company) 5.25% due in 2018 was trading at a spread of 220bps on March 12. On that day Sysco announced a new 10-year deal at a spread of 260bps. So the new issue concession was 40bps.

The new issue concession exists because you need to pay investors some extra yield to get them to care. You'd think a company like Sysco (rated A1/A+) would have a relatively light new issue concession. Its not a terribly cyclical business, good rating, not a big issuer so accounts would have room to add the name, etc.

Now a name like Simon Property would seem to be the opposite to me. Should require a gigantic new issue concession. The people who want to bet on REITs probably already own enough of the name, so you'd need to put such a large yield on the new issue to attract non-REIT buyers. Before today SPG 6.125% 5/18 traded in the 9.7-9.9% yield area in recent days. At 11%, that was a little more than 100bps of new issue concession. I thought that wouldn't be enough. At least I figured this is going to take a bit of work on the sales force's part to get these bonds done.

Turns out I was wrong. I got the message about the deal at 7:30 AM. By 8AM the deal was subject, meaning they weren't going to take any more orders. SPG even upsized the deal to $650 million and lowered the coupon to 10.35%. So ultimatelty the new issue concession was something like 50bps. About the same as Sysco!

Now this becomes a bond to watch. If it trades stronger from there it could entice other relatively high quality REIT names to come to market, which would simultaneously calm REIT stocks. If it trades weaker, it will be all that harder for other REITs to refinance their debts, with obvious consequences.

Wednesday, March 18, 2009

Told you...

Told ya on the Fed buying long bonds. For once I got a contrarion call right.

I suppose I could hot wire this thing...

I expect the Federal Reserve to announce a program to buy long-term U.S. Treasuries. If not at today's meeting, then soon. Interestingly, most commentators I read don't expect the Fed to move in this direction, but to me it seems too easy not to do it.

The Fed's big fear is deflation. We know the Fed has had the printing presses in high gear for several months now, yet still consumer prices barely move. Today we got CPI, a meager 0.2% over the last year. The cash the Fed is producing isn't turning into consumption. As I've said many times, if consumers don't spend more money, at least nominally, there can't be inflation.

Inflation nuts like to complain about the rapid growth of monetary aggregates. M2 for example has risen 9.8% in the last year, or $736 billion dollars. But note that this has almost all translated into excess reserves at banks, which have gone from about $1 billion a year ago, to $622 billion today. In practical terms, money available for consumption is falling.

If the Fed wants to create inflation, it is going to need to overwhelm banks desires for additional excess reserves. That's going to be very tough given that banks are looking at continued increases in loss reserves (despite Citi/BofA's claim that they are profitable). BCA is predicting an additional $1 trillion in losses at banks before the credit crisis is over.

To this end, the TALF is great idea. This program aims to stimulate consumer lending directly, bypassing banks, by reinvigorating the asset-backed securitization market. Already Nissan is doing an auto loan securitization tomorrow, and another major manufacturer is going to follow suit this week. These two deals will combine for $5 billion.

That's all well and good, but it won't address the problem that consumers might not want to borrow. Household liabilities are currently 134% of disposable income, according to the Fed's Flow of Funds report. In addition, households have also seen their net worth decline by $13 trillion. Consumers must continue to save aggressively in order to offset these losses. And despite what some Keynesians say, consumers need to have a decent asset base before a lasting recovery can take hold.

But a lasting recovery can't happen under deflation. Deflation has more destructive power than half the starfleet. Deflation will push home prices even lower, thus exacerbate the problem of negative home equity specifically, and wealth destruction generally.

Currently the Fed is buying Agency debt and Agency mortgage-backed securities (MBS). That program has been a success so far in bringing down spreads on those bonds, especially considering the massive flight away from these securities by foreign buyers.

But that's just the thing: the Fed has brought down the spread on these bonds. The Fed program has helped prevent mortgage rates from rising in recent weeks as Treasury rates rose. But we won't see mortgage rates actually fall until Treasury rates fall. Remember that MBS typically have servicing spread of 50bps, meaning that if investors will buy MBS with a 5% coupon, that translates into a 5.5% actual mortgage rate. So if the Fed wants to see mortgage rates at 4.5%, they have to get investors to buy mortgage bonds at 4%. Investors simply aren't going to buy a mortgage security at a 4% yield if the 10-year Treasury is at 3%.

Forcing Treasury rates lower will be relatively easy. The Bank of England has already set the precedent. On March 5, the Bank of England announced it would be purchasing up to £75 billion in gilts over the next three months. The day after the announcement, even before the first actual purchase, the 10-year Gilt had already fallen by 30bps.

When Treasury yields fall, it puts indirect pressure on all other yields. No other segment of the investing world is so instrumental in pricing so many other investments. The Fed could buy MBS, and bring MBS rates lower, then buy corporates to bring those rates lower, then buy ABS, and munis and CMBS, etc. etc. Or it can just buy Treasury bonds and bring all rates lower at once.

Not only would forcing Treasury yields lower be impactful, it would also easier to achieve. The MBS market is about $8.9 trillion and is made up of thousands of individual securities. By contrast, there is only one 10-year Treasury bond, with about $40 billion outstanding. All the Fed has to do is target the 10-year Treasury and all rates will react substantially from there.

Friday, March 13, 2009

China: I just as soon kiss a Wookie

I feel compelled to comment on this China bullshit. You've already read the story, but in case you have been living under a virtual rock here it is.

Ohmigod! China is going to sell their Treasuries! We all gonna die!!

Look, Wen Jiabao, don't make threats when you have nothing to actually threaten. Where are you going with your trillions? Japan? Yeah, they know how to handle a banking crisis. One of these decades they'll get themselves back on track. Eurozone? Yeah, everything is just peachy over there. Except for Fortis... And BNP... And UBS... er... Britain? Uh, Lloyds, HBOS, etc.

I'm not being jingoistic here. Its just that there is no market in the world large enough to take China's money other than the U.S. That's a fact. And as far as diversifying, every where else in the world is as bad or nearly as bad as the U.S.

And the media and half the hack bloggers just eat it up. Look, I'm not happy about the U.S. deficits either, but to suggest the U.S. is risking its status as a credible nation? Its tantamount to calling Michelle Obama fat during the U.N. recess time. Ridiculous.

Memo to Wen Jaibao: You are along for the ride. Get used to it.

Thursday, March 12, 2009

GE's AAA: The End of an Era

Its the end of an era for bond investors as General Electric finally loses its AAA rating with S&P. Moody's will follow suit in a matter of days, I'd expect.

I have little to say other than to claim GE is currently a "AA" risk is just as crazy as to say they are "AAA" for all the reasons I've discussed before.

Anyway, I thought I'd dispell a myth. I keep hearing claims that GE isn't "trading like a AAA."

First of all, GE is the AAA corporate bond market. So I don't know what "trading like a AAA" means if it doesn't mean GE. Below is a pie chart of all bonds in the Merrill Lynch AAA corporate bond index.

Even given that, GE never did trade like a AAA, if you define it as trading better than a AA. Look at the chart below. GE has traded above AA-rated industrials for years.

Just more proof that the media doesn't know what they are talking about.

Wednesday, March 11, 2009

The Bad Bank: We're only going to have one shot at this

I've written several times about the Bad Bank plan. I believe its critical to restoring confidence in our financial system, and while I don't expect it to "fix" the recession, I do think its a necessary ingredient to the U.S. economy finally moving forward. I've made some loose proposals in the past about how the Bad Bank could work, but after continued thought, I'm proposing an even more detailed idea. Again, this is in the spirit of exchanging ideas, I'd love to hear your comments.

I'll start with some assumptions.

  • Banks and other financial institutions have two flavors of problem assets: loans which are not marked to market and securities which are.
  • The point of the Bad Bank is to improve bank balance sheets both in terms of reduced leverage as well as visibility.
  • Buying assets at so-called "market" levels does not serve the above purpose.
  • While protecting tax payers is obviously important, creating a Bad Bank which doesn't materially improve financial conditions is a waste of time and money.

Note that because loans and securities are being accounted for differently, it creates a material difference in how much the Bad Bank must pay to actually improve a bank's balance sheet. More on this later.

We start by hiring four asset managers. Say its PIMCO, Blackrock, Fidelity, and Accrued Interest (of course! Its my damn plan). Each would be given $100 billion to manage, and would also be given access to a Fed-based credit line of $200 billion each. The loans would be TALF-style, no re-margining, term loans that can be repaid at any time. Each firm would be paid a hedge-fund style fee, i.e., with a performance-based element.

For securities, banks and other financial institutions (I'd open it up to pretty much anyone) there would be weekly auctions. On Monday, firms would submit the securities they'd like to sell. There would be some kind of limit on how much any one bank could put out for the bid on any given week just to keep it manageable. The four firms would then be required to put some kind of bid on each item on Friday. No passing. No more of this "there is no market" stuff.

The sellers would be permitted to put a reserve price, but on no more than half of the bonds offered for sale. What wouldn't be helpful is for firms to put their entire liquidity portfolio out for the bid and then pull everything back after getting a price. That wouldn't improve transparency at all.

The price though won't come in cash, but in stock. More on this later.

Now for the really tricky part. Loans. I'm talking your old-fashioned bank-held whole loans. Mrs. Smith's mortgage. Those are not marked to market, and thus are currently held at par less some reserve for loan losses. Bank of America, for example, only has a 3.5% allowance for losses on their home equity portfolio. As mentioned above, unless these assets are purchased near book value, there's no point in buying them at all.

So here is my radical solution. The Bad Bank buys all non-delinquent residential loans at full face value.

Now wait, don't get too angry just yet. Banks who wish to sell residential whole loans to the Bad Bank must build pools of loans that meet certain criterea. This would be relatively easy for residential loans. For example, if Bank of America wants to sell $100 billion in home equity loans to the Bad Bank, they can't just sell the $100 billion of ugliest shit they have. There would be min/max average FICO, OLTV, average loan size, etc. required. We wouldn't have to make these restrictions overly stringent, but it would assure that the Bad Bank wouldn't wind up with just toxic waste.

Commercial loans and delinquent residential loans would go through the same bidding process as securities. This probably means that banks won't be selling many of these loans, but that's OK. We don't need to completely bleach bank balance sheets, just a good rinse off will do.

As I said above, banks wouldn't get cash, at least not in whole. They'd get stock. Remember that banks aren't suffering for a lack of cash. Banks have some $673 billion in excess reserves...

What they lack is certainty and transparency. So the government buys securities and commercial loans at whatever the bid-determined price is in exchange for stock in the Aggregator Bank. For loans, the bank would get 75% of the face value of their loans in shares and 25% in a subordinated residual.

The principal value of the common stock of the Aggregator Bank would be fully guaranteed by the Treasury. It would pay a dividend equal to all interest on all securities as well as 75% of the interest from whole loans. The other 25% would be retained and potentially paid back to the original bank (the subordinated interest holder), assuming the loan portfolio as a whole met some pre-determined performance standard.

Notice that if the selling bank realizes reasonable performance on their loans, then they are no worse off for having participated in the program. This incentives "good" banks to participate, thus freeing up loanable funds. If loan performance is poor, then the Aggregator Bank retains the excess interest and principal to mitigate tax payer losses.

Notice that this plan doesn't involve any real cash outlay. The Aggregator is trading stock for assets, with the government standing behind the Aggregator's stock. Over time, the government should hold an IPO of the Aggregator's shares, with banks permitted to sell their shares for cash at whatever price the market will bear. Over time, share buy backs would be held with principal returned from the loans. At some point there would have to be some sort of closing transaction as eventually the entire loan portfolio would have paid off.

Now I know what the complaints will be. Tax payers take most of the risk and don't have a lot of upside. True. Problem is that in order to actually fix the problem, tax payers have to take most of the risk. You can't erase risk from the system, only redistribute it. If you want less risky banks, then tax payers have to front the risk. Honestly with my plan, tax payers take on less risk that simply handing cash over to banks, which is what we've been doing so far.

In fact, I fear its a misplaced desire to "protect" tax payers which will ultimately cause the Bad Bank to fail. If the Bad Bank only buys good loans or only buys bad loans at punitive levels, it won't help the situation.

Clumsy and Random Thoughts on "The Bottom"

Yesterday had to set a record for pronouncements of a Bottom (tm) on CNBC. I've said many times that I really hate the sport of bottom calling. First, I think most investors who try to time bottoms wind up losing money. Second, I think even thinking in terms of a bottom winds up distorting one's thinking, focusing you on the immediate term movements rather than fundamental value. Bottoms (tm) are mostly about fear anyway, so anyone who thinks they know where the bottom is is making a statement about market psychology.

As an aside, I absolutely don't get the people who are now doing 90-year SMA charts or measuring resistance points from the 1997 lows. I'm not condemning charts as an investment tool, at all. But looking back 90 years and pretending any of that is relevant is dumb.

All that being said, I sure wouldn't bet that we've seen the bottom. Its possible but not my view.

In order for the economy to start turning around, we must deal with bad bank assets. Ideally, we'd get a decent government-led bad bank plan. I am working on a new idea along these lines right now. As much as I believe a so-called Aggregator Bank could work, I'm not optimistic that the government will successfully put one together. More likely is that the government announces a plan to cleanse bank balance sheets that looks good initially, but the details wind up somehow circumventing the program's purpose.

Second, I think that many investors are overly focused on housing right now. As a result, when housing starts to improve, they will start to buy. I actually think housing will start improving a good deal ahead of general economic improvement.

Why? Because a combination of government programs and time are starting to make progress in getting home inventories down, or at least to where inventories aren't rapidly rising. Home are relatively affordable vs. renting again, and good borrowers are finding it easy to get a loan. I think that in less than a year, home prices stop dropping.

But remember that recessions are the result of necessary adjustments in how companies finance their activity. Where once liquidity, availability of debt financing, counter-party solvency, etc. was all considered a given, now it isn't. It will take years for companies to restructure themselves to this new reality.

Pile on top of that the massive loss of wealth at the consumer level. This will force much higher savings rates and higher labor force participation (people getting second jobs or putting off retirement.) While this is probably a long-term positive for our economy, it will require a near-term adjustment. It will mean we've got too much retail capacity in this country, for one. Again, this adjustment will take years to play out.

And that doesn't mean that the economy contracts for years and years, but that housing alone won't fix the economy. Maybe pre-Lehman/AIG/GSEs/WaMu/Wachovia housing alone could have pulled us out of recession, but not now.

Anyway, back to the stock market. Stocks are forward looking, so the Bottom (tm) will almost certainly come before the economy starts recovering in full. So sure, its possible that I'm overly pessimistic and we've already seen the bottom, especially if the Aggregator Bank actually winds up working.

But I'm betting we still go lower.

Monday, March 09, 2009

Han will get that shield down...

First, let me start with an analogy.

I have a good friend, also in the finance business, who bought a condo about 2 1/2 years ago. It was part of an apartment building rehab, but is located in a very sought-after zip code in suburban Baltimore. And its a beautiful place. When my wife and I first went there she jokingly said we should sell our place and buy his.

Unfortunately for him, not only did he buy at the top of the housing market, but the builder doing the rehab went under and sold the project. The new owners are going to continue the rehab, but leave it as rentals, not convert to condos. So that's absolutely destroyed the value of his place. I'd guess in the -50% area or some such.

Now this guy is relatively young, and while I don't know much about his personal finances, I know he doesn't have huge amounts of liquid assets. So I can safely say that he owes more on his house than his entire net worth.

And yet he's earning a good income, as does his wife. In fact, he told me that he is well under the debt-to-income number that Obama's foreclosure relief plan is targeting. So I have no reason to believe he's going to default on his loan. Still, based on a simple assets vs. liabilities calculation, the dude is insolvent.

Obviously the bank would be incredibly stupid to foreclose on him now, even if the bank had that right. Allowing my friend to remain a "going concern" makes much more sense. Granted, the risk my friend poses has gone way up, as there is no longer any equity cushion. But if the bank were to foreclose now they'd be looking at a 50ish percent loss. Whereas if they look the other way and let the cash flows play out, my friend is very likely to pay off his loan.

Now stepping back, there are a lot of financial institutions in this same boat. They have gigantic paper losses, yet little in cash flow interruption. This brings us to the GE Capital discussion of the last couple days. I've mentioned a fundamental problem the finance sector is currently dealing with. This is essentially the source of my kobayashi maru title from the other day.

  • Financials have made many investments (be it in loans, properties, securities etc.) that they wouldn't make today, at least not at the original terms.
  • However, some of these investments will eventually work out alright from a cash flow perspective. Some won't.
  • It stands to reason then that some financial firms will own more "good" investments and some will own more "bad" stuff. Only with time will we really know who is which.
  • Unfortunately, the market isn't giving firms much time. The door for raising new equity money is now pretty much closed for any financial, and wild trading in CDS is stoking more fear.

Ideally we'd like to give financial institutions time to sort out who is who here, but private investors aren't going to accommodate. I mean, as a bond manager, I wouldn't be waiting around for three or four years to see if GE Capital can work through their problems. Investors as group, we made that mistake with Bear Stearns and Lehman and AIG and Merrill Lynch and WaMu and Wachovia and GSE preferreds and Citigroup etc. etc. etc. etc. etc. Most pros got stung or nearly stung with one or more of these disasters. We aren't waiting around any more.

This should be the focus of government programs to cleanse the financial system. Creating time. Otherwise, as Keynes said, we're all dead.

Thursday, March 05, 2009

GE Capital and Credit Default Swaps: The Jump to Hyperspace

Some of the discussion on yesterday's post regarding GE Capital turned to the problem of credit default swaps. Back in October, I outlined some of the major problems as well as the potential solutions to the CDS problem. You can read that piece here if you'd like, but otherwise here is a quick summary of the problems:

  1. CDS aren't really that liquid. In order for any market to be liquid, there needs to be a large numbers of buyers and sellers. In the old days, the big dealers were always willing to write CDS to their customers because the risk was easily passed off in some other manner. Either sell it to AIG (snicker) or put it into a synthetic CDO or some such. Today dealers aren't making a market the way they used to. They have their own credit problems to work out and aren't willing to leverage their balance sheet on this kind of trade.
  2. Thus when an event leads investors to grow concerned about a company, everyone wants to buy CDS protection at once. Yet who is willing to sell? Goldman? Morgan Stanley? There aren't a lot of players left. And let me tell you something. If Goldman is willing to sell you the CDS, it won't be 10bps back. It will be 10 points back.
  3. The problem becomes that much bigger with a name like GE Capital, which is so widely held. Goldman might be willing to quote you CDS on $10 million of some off-the-run name at a stupid price, but when the whole investing world wants protection on GE at once, its another story. No one has the balance sheet to accommodate the demand.
  4. Exacerbating this problem is that bonds aren't easy to short. As a result, firms that write CDS are almost always writing naked.
  5. Putting all this together, CDS are infinitely more manipulable than stocks. If I can't see where something is trading and at what volume, only that the quoted price is 10 points wider, my only conclusion is that the credit is cratering.

Many of these problems could be solved with exchange-traded CDS. This would open up the writing of CDS to a much wider audience. If it were done with regulated margin requirements, with the exchange acting as universal counter-party, there would be far less contagion risk related to a failed counter-party.

Wednesday, March 04, 2009

General Electric: Kobayashi Maru

Credit default swaps on GE Capital traded as wide as 20 points up front area this morning. For some color on what this means, in the days following Lehman's collapse, Goldman Sachs never traded this wide and Morgan Stanley might have ticked this wide, but only for a day or two.

In my opinion there are a number of things coming together to create this problem, beyond the obvious that GE was highly exposed to various areas of the economy now weakening. First, GE may have had a legitimate AAA-rated business model if one assumed that access to short-term financing was always and everywhere a given. Now that's obviously not the case. You simply can't make the case for any firm being rating AAA who needs constant access to short-term markets. That's even forgetting all about GE's exposures. So GE will be downgraded from AAA, its only a question of when and by how much.

On top of that, there are thousands of investors who bought GE securities over the years with the attitude that "hey, its AAA! What's the risk?" Some of those buyers had dumped the bonds over the course of the last year as it became increasingly obvious that GE would be impacted by the financial crisis. Bill Gross was saying as much on CNBC this morning. These buyers include everyone from big foreign investors to little retail accounts. And why can't I shake the feeling that it also includes Mr. Gross himself?

And remember that a lot of the same people got burned with AIG, which was also AAA-rated just a few years ago.

GE Capital's business model can be boiled down to this: every risk has a price, and we'll price every risk. Note that this was basically the same business model AIG was running. Maybe GE is running it better, but its the same idea. And that's not to say that GE is going to have the same fate as AIG. But consider the conundrum: GE has huge de facto leverage which it needs to reduce. But it cannot sell enough assets at today's distressed prices to actually reduce leverage. You'd like to think that if the assets are good, GE can just let time and normal cash flow solve their problem.

But that isn't a realistic option. First, if ratings agencies downgrade GE Capital enough they'll have to post additional collateral against existing contracts, and that's exactly what the proximate cause of AIG's collapse. Second, GE Capital really can't operate with less than a AA rating or so. The funding costs would be too high. Maybe they could get away with A, but certainly not BBB. But under current circumstances, I really think BBB is the right rating. Again, you'd like to think GE Capital could go into quasi-run off and eventually regain a decent credit rating, but I just don't think market conditions allow for that sort of slow transition.

This is also why I doubt they could do a spin-off of GE Capital. If GE combined is looking at a A-level rating, GE Capital alone would either get a much lower rating, or GE Inc. would have to pledge even more cash to GE Capital in the spin-off. On top of all that, from a shareholder perspective, if you believe in GE Capital long-term, why sell now when valuation is going to be at a minimum?

These kinds of no-win scenarios are an unfortunate consequence of current economic conditions. Firms need to rejigger their leverage and asset mix, but the problem is so universal that no one has the cash to transact. Then you have companies who probably could have survived had they been granted the luxury of time, but no such luxury is available.

What would really help GECC is for the TALF to be expanded such that GECC could unload assets at decent valuations into the secondary market. Or else the Aggregator Bank helps them out. Otherwise its difficult to see what good options GE has.