Leverage doesn't kill investors. Bad investments do.

Every one wants to blame the financial crisis on leverage. There was a glib comment on the blog the other day which reflects a common view:

"Sad to see the "cure" for overleveraged, undercollateralized balance sheets to be... more leveraged finance."

No offense to Jonathan intended, as his view probably reflects the majority of opinions among those who follow finance. But I find blaming leverage per se to be a weak argument. Thus I don't see bringing some degree of leverage back into the market as a negative. Furthermore, I don't think that simply blaming leverage will be constructive as we try to construct a regulatory structure to prevent similar meltdowns in the future.

Let's consider the case of a CDO of ABS. To make life simple, we'll assume CDO was constructed from mezzanine bonds from HEL deals. This would be securities similar to the ABX 2007-1 A index, basically the segment of major home equity deals from early 2007 which were originally rated "A."

The HEL deals were structured something like the following (although I'm presenting a simplistic version, the point stands.) I'm assuming $100 million original face, with the underlying mortgages having a 6.75% rate.

Senior: 5.75% coupon, $80 million

Mezzanine: 6.50% coupon, $15 million

Subordinate: 8.00% coupon, $5 million

All principal cash flows to the Senior until it is entirely repaid, then to the Mezz, then to the Subs. Interest payments are only made to the mezz and subs if the senior interest obligations have been met. (Don't get hung up on the math right now, it won't be important to my point. If you have questions about ABS and/or CDOs, e-mail me. Accruedint AT gmail.com).

In a CDO of ABS transaction, the CDO would buy a series of mezz bonds, then repackage them into a similar senior/sub structure. So now let's say we have a $100 million CDO which buys the mezz of 50 different HEL deals, all structured similarly to above.

The CDO builds its own senior/sub structure as follows:

Senior: 5.45% coupon, $80 million

Mezz: 6.00% coupon, $12 million

Sub: 8.00% coupon, $4 million

Equity: $4 million

Same deal as above, where the senior gets all principal and interest due before the other pieces. Only once all other classes get their principal and interest does any cash flow accrue to the Equity. One might think of the sub/mezz/senior pieces of the CDO as providing leverage to the Equity. Since the total assets in this deal is $100 million, with equity of $4 million, we have 25x leverage.

Its easy to see why the CDO of ABS world came crashing down. The ABX 2007-1 A is now trading at $2.5, or a 97.5% loss vs. the original face. So the CDO built on securities similar to ABX would have almost all principal in the deal wiped out entirely. Even the senior most piece of the CDO, which would have been rated AAA originally, would have suffered huge losses.

But was it the 25x leverage that was the problem? Not at all. Substitute any number for the equity, and the structure still doesn't work, because the underlying collateral is crap. If you are going to try to tell me that leverage caused the meltdown, then you'd need to show me how a different leverage figure would have prevented the problem. Here is an example of a leveraged vehicle that fails at any haircut.

Now one might say that if the ratings agencies would have required more overcollateralization, these CDOs never would have been created. Perhaps. But again, if leverage isn't the problem with the security, then allowing too much leverage wasn't the ratings agencies' primary mistake. The real problem is that the ratings agencies never considered the binary nature of these structures. If you build a CDO based on all mezz consumer loan ABS, and consumer loans perform poorly, then the whole deal is threatened. We didn't need catastrophic losses on consumer loans to impair the senior-most pieces of these CDOs. Had sub-prime consumer loans suffered a mere 10% loss rate, the CDO would have suffered a 50% loss rate! That would have resulted in the "AAA" rated Senior piece suffering a 30% loss. That isn't acceptable for a AAA-rated asset.

It isn't like the ratings agencies should have rated these types of CDOs AAA at some lower leverage level. They shouldn't have rated these types of CDOs at all. We talk about toxic legacy assets. These CDOs were toxic from the word go.

Now consider this. Why didn't the ratings agencies figure that consumer loans could go all go sour at once. Why did they assume that a 10% loss rate was nearly impossible? Or if you want to damn the ratings agencies as mere minions of the investment banks, why were people buying these CDOs? Those investors must also have assumed that the 10% loss rate was nearly impossible. Else they wouldn't have bought the bonds at all. So why was every one so confident?

We all want to blame some nefarious party, because that would feel better. It is more satisfying to think we were all duped by the evil geniuses on Wall Street. But what if it was as simple as the Fed having succeeded in dampening the business cycle that people started to assume volatility would remain permanently low? What if the fact that previous disturbances that could have had greater contagion (1987 crash, Asian Currency crisis, Russian Debt crisis, LTCM, Y2K, Dot Com bubble, 9/11, etc), didn't. People began to assume the age of crashes was over.

Now I'd be a fool to say that leverage played no part in the crisis. Clearly financials got over-leveraged. Part of the problem is that with so much leverage, some financials (AIG, Lehman, Bear) didn't have enough time to see if their asset bets would play out. But why they got over-levered was a response to contracting yield spreads. Or put another way, ROA was dropping so in order to get the same ROE you needed more leverage. Spreads were contracting (and thus ROA falling) because there was greater confidence in a more stable economic horizon. As ROA fell, too many fell into a trap of buying poorly constructed securities to get a relatively small amount of extra yield. And before you try to say that no one saw ABS CDOs as riskier, consider that the senior-most ABS deals always yielded 20-30bps more than the senior-most commercial loan-backed CDOs. Every one knew that consumer ABS-backed CDOs were more risky!

So ultimately, leveraged investing comes down to picking good assets first, then getting the leverage right. The crisis has been brought on by poor asset decisions more so than too much leverage.

FASB: The Dark Side clouds every thing

The new FASB ruling is getting more play than it deserves.

I've written on mark-to-market many times. I've always felt it was a good concept but has been applied incorrectly. When the rules were written, it was never assumed that generalized risk aversion would ever rise to the extent that it has. Thus the rules assumed that a $30 decline in a bond price would always and every where indicate a security-specific problem. The rules (and/or the auditors) also assumed that securities that seemed similar at a glance could be used to value each other. They never assumed that various securities would ever become as granular as they eventually became. For example, a whole-loan RMBS with 15% California exposure suddenly was valued drastically differently than one with 25% CA exposure. But both were valued off the ABX as if they were the same, because the ABX was the only thing trading.

Anyway, the key thing that changes with this FASB guidance is the assumption of distress. Now any trade that occurs in an inactive market is presumed to be a distressed trade unless proven otherwise. I'd expect this means that most Level 3 asset prices will become more PV model-based and less trade based.

BUT...

I'd argue that this won't result in banks writing up their asset valuations. Think about it. Say XYZ Bank announces some huge quarterly EPS figure, but when the analysts look deeper into the number, it turns out it was all paper gains on Level 3 assets. Investors would universally pan the earnings figure, claiming it was all phantom profits on marks to make-believe valuations.

Conversely, let's say the same bank reports break-even earnings with no change in Level 3 and a healthy increase in loan loss reserves. Now what does the market think? Analysts would say that the bank has potential latent gains in their Level 3 portfolio that haven't been recognized.

This market is all about imagination. If you are a bank (or any financial), the market isn't going to just accept your balance sheet as reported. The market is going to try to imagine what your balance sheet is really. Since no one knows what it is really worth, investors are going to imagine. I argue that a bank is better off convincing the market that it is being too conservative, thus guiding the imagination to better times.

Otherwise the bank will only stimulate the imaginations of the "its all worthless" crowd, which I realize is the majority of the blogosphere. I don't get this point of view, and I think its all rooted in some sort of visceral desire to see the banking system crash and burn. I think Jim Cramer said it well on TheStreet.Com today:

"The first side is the "it doesn't matter and it is bad" camp. This is the camp that says it [the FASB ruling] is a mistake because it will give the banks too much latitude, and they don't deserve it. "Deserves," as they say in Unforgiven, "got nothing to do with it." This is a completely worthless position that makes you no money. Who the heck cares whether they "deserve" it? What is this, some sort of civics lesson? We are now going to invest on whether someone should be punished? This is about money. I could care less about "deserves". "

Its similar to my position on politics. As an investor you need to forget about what "ought" to happen and worry about what will happen. That's how you make money.

AI system? Not much there...

Apparantly my little blog has reached the galactic core. Investorfolio has added Accured Interest to their directory. I call upon both my loyal readers to follow this link and give a rave review. I call upon the hoards of readers who hate the blog to follow this link and give a scathing review.

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UPDATE

So now Accrued Interest is #2 on Investorfolio's top hits list... and the blog I told you not to go to as a joke is #3... what is that telling you?

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.

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.

"wow..."

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.

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.

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.

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.

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.

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.

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.

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.

The bubble in TBT

Just a few weeks ago, a number of commentators were calling the Treasury bond market a bubble. The 10-year Treasury had fallen to nearly 2.00%, and the 30-year bond had fallen to 2.50%. But since that time, the 30-year Treasury has risen by 100bps, representing a 19% decline in price.


Now if you really want to find a bubble, try TBT, the ProShares UltraShort 20+ Treasury ETF. This fund is designed to delivery -200% of the return of the 20-year and longer segment of the U.S. Treasury market.


First take a look at the shares outstanding in TBT. This is an excellent proxy for how popular a short US Treasury trade has become.



What's one of the conditions for a bubble? Parabolic increases in demand? The outstanding shares in this ETF has gone from about 7 million shares on 10/31 to nearly 63 million shares now.


Treasury bonds should be hitting new lows in yield. Economic and liquidity conditions are as bad as its been since the Depression. Deflation is a more serious threat than its been since that same time. Why shouldn't interest rates fall to record lows? Why shouldn't they stay there?


Yet its fashionable to scoff at Treasury rates, even now that yields have backed up. Some fear inflation, due to the massive stimuli currently being thrown at the economy. But with financial institutions as well as households rapidly deleveraging, there simply isn't enough spending to create inflation right now. Some day I hope inflation becomes a problem, but we're a good ways off from that. Consider that, according to Merrill Lynch economist David Rosenberg, that the balance sheet of U.S. households has declined by $13 trillion. The expansion of the Fed and the Treasury's balance sheet has been only 1/5 that amount.


Others fear supply of Treasury bonds. But the reality is that savings rates world wide are set to increase, creating more demand for safe assets, not less. We don't need to worry about Treasury borrowing crowding out private sector lending. Not now at least.


Finally, the Fed has a strong interest in keeping Treasury rates low. There won't be any economic recovery if mortgage rates start rising. The Fed won't be able to maintain a mortgage rate south of 4.5% if the 10-year Treasury rises above 3%.


And here is a little secret: The securitized mortgage market is about double the size of the Treasury market. It will be much easier for the Fed to manipulate Treasury rates lower than to manipulate mortgage rates!


Income-conscious investors may be loathe to buy up long-term Treasuries at current yields. Those investors should consider any very high-quality non-callable bonds: government agencies, municipals, and some corporate bonds would all make sense.

Clumsy and Random Thoughts

Just as Geithner is about to speak...

• They want to call the Bad Bank an "Aggregator" bank. Does that mean we can call it "Aggie Mae?" I think back to Rod Stewart... "Oh Aggie I wish I'd never seen your face..."
• The TALF remains an under-rated part of the effort to jump-start consumer lending. The Fed will have a conference call on the TALF on Thursday 2/12 at 3PM. The number is 1-866-216-6835, Access Code 296081

TARP II: Find a way into the detention block!

Details are emerging about the new financial rescue package. Some of the items the Wall Street Journal has reported sound far more market-friendly than what I had feared.

The centerpiece is the bad bank. While not exactly what I talked about last week, this bad bank will be funded with private sector money. Its daring, but if it can work, then I think it will achieve some of the goals I laid out in that post. A privately funded bad bank should involve less government intervention than would otherwise be.

Another key element will be a FDIC-insured covered bond program. I talked about creating a government-backed covered bond program backed by some limited government guarantee. Now it looks like it will be a reality. Basically banks will be able to issue FDIC-insured debt with maturities as long as 10-years as long as that debt is backed by loans. I'd expect this to be restricted to new loans, because the idea is to get credit flowing again.

Remember that covered bonds differ from securitizations in that the debt is an obligation of the issuing bank no matter what. So even if the loans which "cover" the bond go into default, the bank still has to pay. With a securitization, the bank sells all its risk to investors in the securitization. From a moral hazard perspective, the beauty of the covered bond program is that the risk stays with the bank who originated the loans. The FDIC (i.e. tax payers) are only on the hook in the event that the bank goes under. And we're already on the hook for that!

From a "fix" the economy perspective, the covered bond program gives banks a guaranteed profit as long as it can underwrite good loans. The bank's cost of funds for 10-year FDIC insured covered bonds would be about 4.5% (my own estimate, maybe lower). How easy is it to make loans well north of 4.5%? By implementing this program, the government is telling banks not to worry about their funding sources, just worry about lending the money to worthy borrowers.

The last piece of this bailout that I think will really matter is the TALF. Similar to the covered bond program, the TALF will guarantee profits to banks and other financial institutions as long as they can make good loans. Combined with the covered bond program, this should eliminate the hoarding of cash at banks.

The real trick is how the government is going to incent private investors into the bad bank. I think that if the government guaranteed some percentage of the initial purchase value, private investors would come in. I'm not sure how high this number has to be, but there is a number.

TIPS: What know you of ready?

I recommended TIPs vs. nominal bonds in an earlier article. Since that time, the 10-year Treasury is down 4%, while the 10-year TIP is slightly higher. I think TIPs are probably overbought here, and its time to take profits.

First a chart of the breakevens. The blue line is 5-year, the green 10-year and the red 20-years. Breakevens measure the expected future inflation rate as implied by the TIP trading level versus Treasury bonds.



All three have bounced nicely off the lows, with the 10-year breakeven rising from zero to about 1.1%. For a buy and hold investor, that might still seem too low. I still think the Fed's massive expansion of its balance sheet will eventually cause above average inflation reads. But that's probably 1-2 years down the road. Measured CPI inflation could easily be negative, perhaps sharply so, in coming quarters. Will CPI average 1.1% over the next 10-years? Probably not, but it could.

Notice that there hasn't been any confirmation of an impending inflation problem in other markets. Since the 10-year breakeven hit bottom on 11/20 (green line on the chart below), the dollar is basically unchanged (yellow line) while commodity prices have fallen (white line).



If there is really increasing concern about inflation, then the dollar should be weakening and commodity prices should be rising. The fact that these indicators aren't confirming the rise in TIPs breakevens suggests that investors have either become enamored with TIPs, or have abandoned Treasury bonds. If there really were an inflation spike around the corner, we'd have confirming data from other markets.

And it isn't like there has been any encouraging economic news in recent weeks to stoke inflation fears. The key drivers of our current deflation problems is wealth destruction from housing and deleveraging in the financial system. Both these problems continue unabated. We won't get realized inflation until consumers start spending money again. Just look at today's jobs report! Spending will eventually pick-up, but not in the near term.

One can argue that the rise in breakevens has more to do with a sell-off in traditional Treasury bonds than anything else. I think the sell-off in Treasuries is also over done, as investors have become paranoid that increasing Treasury issuance won't be easily absorbed by the market. In a world that is rapidly deleveraging and desperate for safe stores of cash, the U.S. Treasury market will be well-bid. Volitile, due to a lack of market-making,

The bottom line. Eventually inflation will return to the 3% area, and maybe even a good deal higher. But 10-year TIPs are probably fairly valued with breakevens around 1-1.5%, given the fact that the eventual acceleration in prices is a long way off. Given how quickly breakevens have risen, its bound to pull back. Re-establish closer to 0.50%.

I'm back

AI returns after a nearly 2-week hiatus. Well, semi-hiatus as I was traveling and not able to write much. If you've e-mailed me and I haven't gotten back, I'm sorry.

While every one is talking about Monday's big TARP Episode II release, there's been some other goings on. Big news today is the potential for Fannie Mae and Freddie Mac to be taken on balance sheet by the Federal government. This isn't such huge news from a practical perspective, but could radically change debt trading. Imagine if there is no more agency issuance!

More on this on Monday.

Bad Bank/Worse Bank

So what do we think of Geithner's Bad Bank idea? Is this the solution that will finally fix the economy? Will this mark a Bottom (tm)?

First of all, the universal bad bank idea is much better than how the TARP is currently being utilized, namely equity injections into private banks. When you have the government actually owning private companies, it opens up any number of Pandora's boxes. Already the government is trying to influence how banks operate by forcing them to lend out TARP injections. That's a terrible precedent.

On the other hand, if the government simply buys certain assets from banks, that could be the end of it. Congress could attach certain rules and regulations surrounding the asset purchases, for example, forcing banks to agree to executive pay restrictions. But once the purchases have happened, that could be the end of it.

If you want to some day return to real capitalism, then we need to figure a way to get through the current crisis. But we also need to do it in such a way that government interference in private business is minimized. As long as government owns banks, that isn't happening.

How should the purchases of bad assets be handled?

I'd like to see it done something like this. We form a new company, call it LoanCo. The Federal Government capitalizes LoanCo with some amount of money, say $500 billion. LoanCo agrees to hold weekly reverse auctions. Each auction is held with specific types of mortgages or mortgage securities. For example, one week might be OptionARMs with a certain FICO range, original loan size range, vintage year and interest rate. The next week would be a different set of characteristics.

Each bank would offer to sell their block of loans at some price, expressed as a percentage of original loan amount. LoanCo would have a pre-determined total amount they will be buying. The purchases would occur at the lowest price that "cleared" the market. Essentially, banks would be giving LoanCo limit sell orders. Bank of America might say they'd sell some set of loans at 60% of par or better. If LoanCo gets all the loans they want by paying 30%, then B of A is left out in the cold. If LoanCo winds up paying 70%, then B of A simply gets better execution.

But rather than get cash for the bad assets, the selling bank gets stock in LoanCo. All interest received by LoanCo is initially retained, but all principal is immediately returned to shareholders. The government guarantees half of the principal in these loans. In exchange, the government keeps all interest payments until LoanCo starts winding down and keeps any principal payments over the initial purchase price. So for example, if a loan was sold to the government at $60 but they eventually recover $80, taxpayers keep the $20.

(Note there is a somewhat similar plan being proffered in today's WSJ. Robert Pozen's idea is similar to mine in many ways, but I like mine better).

The advantage of my system is that banks would get capital relief, as LoanCo stock has a guaranteed value of at least $0.50 cents on the dollar. It would also make investors in banks feel more confident, knowing that the value of distressed mortgage assets can't be any worse than half of its current value.

This would also create a somewhat market-based price for the "bad" assets, at least more so than creating some model to determine a price. There is a good chance that LoanCo would suffer from selection bias. Banks would have to submit loans with certain criteria, but they would clearly pick the "worst" loans that fit that criteria. But in the scheme of things, this shouldn't be a deal breaker.

The downside of this plan is that banks get very little in fresh cash, only certainty as to the downside on their assets. But I argue that's not all bad. If we just give banks cash, they are essentially allowed to grow earnings on the backs of taxpayers. By issuing stock, the banks get the capital certainty they need, but have to figure out how to grow earnings on their own.

And I argue that banks will start lending once the fear of another round of bank runs diminishes. The margins on new loans should be excellent. I don't think we need to dole out free cash in order to incent banks to lend.

And the best part about LoanCo is that its clearly a one-time deal. The moral hazard and long-term government intervention problem is limited.