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.


Unknown said...

how do you propose the obama administration goes about creating time?

also, a little off topic, but what do you make of government programs designed to help homeowners directly?

Advant Guard said...

Bank stocks have bottomed. While not recommended for most investors, if you have cash you won't need for 5 or 6 years, there are bargains in several banking names. Bank bonds are also returning mouth-watering yields. (I personally would stay away from Citigroup bonds.)

John (Ad Orientem) said...

Citi is broke. They should be nationalized or simply allowed to go under. I prefer the former but the present policy is just throwing good money after bad.

Anonymous Monetarist said...

Sounds fair...methinks rich folks' bad speculative bets should get a taxpayer bailout ...

While we are at it how about the fella that bought 100,000 shares of
CSCO at 30 in 2007 on margin?

Mr. Margin is callin' him but ..

I mean come on its' Cisco! ... it will be 30 again, in fact based on cash flows you could argue that it should be 30 now.

Why should this fella be penalized because he made an investment that he wouldn't make today, at least not at 30?

Obviously Cisco will get to 30 again.

Only time will tell if it won't get to 30, no way we know that for sure now!

But Mr. Margin is sayin' this fella doesn't have any time.

Or to use your lexicon : only now at the end young CISCO holder do you realize the power of leverage.

If folks don't want to deal with the downside of capitalism they should all become socialists.

The bray of pigs from the legions of Nancy Capitalists?

Save us Daddy Guv, you're our only hope. said...

I am, like you, disappointed with Citi, current stock price and the broad-based misperceptions about the company and its financial position.

xtreeter said...

GE Capital may not be experiencing a major cash flow interruption, yet. However looking at its loan portfolio vs. any realistic cash flow guesstimate (from borrowers' operations), it is easy to foresee many defaults (a major cash flow interruption for GECC) in the not too distant future. Unfortunately, when that happens, it will be too late to exit.

I think it's exactly because investors have been stung by one or several of the disasters you mentioned. Now investor vow to not be stung again ever, at least not while the scar is still fresh. Waiting to see if an institution really in fact does not make it in the future when there are signs of trouble today, is a luxury many do not have.

That being said, I recently took a long position in Citi's Global Sub Nt, at costs from mid to high 50's. Am I crazy with my argument above? Perhaps, but my rationale is: A) Reading the body language from our government, there is no way in hell that Citi will be allow to fail in the "near future". With time, I could gamble on the news flow/sentiment swing in my favor. Hopefully with it will bring higher prices. B) In the event that a government assisted/sponsored restructuring is offered, there is a strong chance the around 60 will be the initial offer (using the initial GMAC restructuring offer as a guide). This would pay off my speculation since my cost is in the 50's.

What do you think AI? Anyone?

Accrued Interest said...

Who let that refugee from The Big Picture in here?

Speculating on Citi's prefs isn't something I'd do myself. I don't want to bet on the whims of this government.

Playing in like Wells or JPM would make more sense to me, since I think those are much better institutions. Not that they might not go down too, but they are much stronger right now.

Unknown said...

On the issue of Bank debtholders being "forced" to take haircuts as a precondition of future bailouts, I have the following question.

Isn't it true that the only way senior creditors can not be paid their scheduled principal and interest by the debtor is when the debtor has filed for Chap 11 protection. Now the government can always nudge the likes of Citi/BofA to make a tender offer on their outstanding senior debt. If the TRACE data shows that 10bln of debt traded at an average price of 50cents to the dollars, then they can make a 60cent offer (similar to what Ford Motor Company is doing). But (this is the important point there) cannot put a gun to the head of the senior bonholders and force them to participate. They are legally within their rights to file a lawsuit.
Only (legal) way senior bondholders take a haircut if the government forces the banks into some sort of pre-packaged bankruptcy. But the side-effects on those actions on pension funds/insurance co/endowments will be too painful. This obviously assumes that the government will do everything in its power to prevent an uncontrolled liquidation of a large financial firm (not another Lehman).

thoughts/comments anyone.

xtreeter said...

I thought Pimco did just as Kabir described with the GMAC tender offer. Another major problem is that a huge chunk of debt issued by banks are carried at par and held in hold-to-maturity accounts of other financial institutions. Forcing a large hair cut would most likely bring a host of newly insolvent financial institutions to be dealt with.

On the other hand, the main foreign buyers of US treasury looks to have dwindling buying power, as China and Japan's trade surplus evaporate. In addition, every major government is facing huge funding gap on their own. The future treasury new issues will probably have to be bought by the fed out right. If and when the unsterilized monetization occurs, making any US dollar debt obligations whole in "nominal" terms will not be a problem. Thanks to the unlimited buying power of the printing press at the fed. As for the price we pay in terms of eroding buying power of our dollar, my hope is I will move into hard assets before the mad rush begins.

Again, it seems my seasoning is defending my bet in Citi's Sub Nt. I am wondering if there is a major hole in by argument?

Accrued Interest said...

I don't know of any legal way that the government can "force" bond holders to take a haircut. Some of this bond holder loss bullshit is coming from the moral hazard crowd, which doesn't care about logic and legal contracts and the like, just punishing people.

Anyway, the distressed exchange that GMAC did several months ago did happen as described. Not all the bond holders consented, and there was no way to force them.

What the government could do is say that they won't give a bank TARP money unless bond holders consent to some sort of tender and exchange.

With sub-notes (or prefs or hybrids), the government may not be able to force losses, but they can subordinate existing holders. I.e., insert capital at a level senior to existing sub note holders.

Think about what happened with FNM/FRE. The prefs are near worthless not because of some government fiat, but because they've been so deeply subordinated.

xtreeter said...

Thanks for the comments, AI.

Yes in deed if Citi becomes nationalized/taken over by the government as FNM/FRE did, they will most certainly subordinate the existing sub debt to a point where it's worthless. I will have to exist before that happens, win or loose.