AIG Seeks Renegotiation of Loan, AGAIN

AIG is once again prepared to ask the Federal Reserve to relax rules on its $60 billion-plus asset disposal program.  Apparently, AIG is miffed about the high interest payments it must make to the Fed on the loan and wants to speed up the asset sales.  AIG is looking at installment payments and other flexible options to make it easier for potential buyers to bid for the assets (at inflated prices) and increase the chances that AIG can extract itself from the government's firm grip.  According to the current deal with the Fed, mind you the SECOND more lenient bailout from the Fed, AIG can only sell assets to bidders paying at least 90% of the price in cash.  Because of this onerous and unfair restriction, AIG is not getting what it deems to be high enough bids, if any, from potential bidders.  Given the current financing environment (i.e. lack of financing environment) and the restrictions on balance sheets (i.e. everyone else is a seller of assets too), this situation should not come as a surprise to anyone with a pulse, (i.e. including my one-and-a- half-year-old toddler.)  If the Fed falls for yet another one of AIG's whiny pleas for leniency to save it from the burden of having to actually pay for its financial sins, I will definitely be one of the bidders in AIG's next auction of a valuable subsidiary.  Instead of offering cash, I will be bidding with a pair of slightly used boots (very stylish), a nine-year-old Jeep Wrangler (still runs great), and a few shares of Enron stock (I'm sure they will pay off eventually, I always buy stocks for the long haul.)  Since I hear this is the type of collateral the Fed is currently accepting in the discount window, I'm hoping to pick up AIG's asset management unit on the cheap.  You see, I have no balance sheet restraints. 

GMAC Claims $6 Billion of the Bailout Pie

The government committed $6 billion in bailout funds to GMAC, the finance arm partly owned by General Motors and Cerberus Capital.  The Treasury purchased $5 billion in senior preferred equity in GMAC that pays an 8% dividend and offered a new $1 billion loan to GM so the auto maker could participate in a rights offering at GMAC.  The new loan to GM was in addition to the $17.4 billion in emergency loans recently announced.  GMAC will issue warrants to the Treasury in an amount equal to 5% of the preferred stock purchase that will pay a 9% dividend if exercised.

Last week, the Federal Reserve approved GMAC as a bank-holding company.  The approval was conditional on GMAC raising new capital, which the company attempted to accomplish through a fancy crappy-debt-for-crappier-equity swap that expired Friday.  GMAC was supposed to raise $30 billion by converting 75% of its issued debt into preferred-stock holdings.  Last week, less than 60% of bondholders had signed on and the offering had been extended four times.  Completely coincidentally, and slightly suspiciously, GMAC announced that it had raised enough capital to satisfy the debt conditions simultaneously with the Treasury's announcement that GMAC had been approved as a bank holding company.  According to the Wall Street Journal's account of the story, it wasn't clear whether the government's intervention prompted or followed GMAC's meeting the capital requirement.  My interpretation of the WSJ's statement is that John Snow, the most politically connected head on the three-headed monster that is Cerberus, is proving that what he lacks in investment savvy, he more than makes up for in Washington connections.  As the former Treasury Secretary to George Bush, Mr. Snow was able to convince the Bush administration in its waning days to help a fellow suffering white, absurdly rich, private equity brother out.  And although Mr. Snow was widely viewed as a terrible Treasury Secretary while at his post, sending Mr. Snow to lobby the government for bailout money was a far more palatable option than dispatching Dan Quayle, the other political clown advisor that Cerberus keeps in its arsenal for government lobbying opportunities when it needs a bailout for its incredibly poor investment decision-making.   

It is easy to argue that a bailout for GMAC is necessary if the government is interested in saving General Motors.  After all, GMAC finances about 80% of the wholesale purchases of GM's cars by dealers worldwide and has traditionally been the largest source of financing for the buyers of the vehicles.  Without access to auto-financing, most people aren't interested or capable of plunking down $20,000-$40,000 for a new car.  But I would've preferred it if Cerberus was forced to cough up a significant amount of new capital alongside the government, or had its equity investment wiped out, much like the shareholders of Fannie Mae, Freddie Mac, and AIG suffered when the government came to their rescues.  On second thought, given how carelessly the government funds have been doled out by the current administration, I'm not sure why I expected anything different. 

Cash Piles Grow in Bank Deposits and Money-Market Funds

Admittedly, the headline should read "Finance Bloggers Desperate for Material on Slow News Day," but this Bloomberg story on growing cash piles is the best I could come up with for interesting reading today.  According to Federal Reserve data complied by Leuthold Group and Bloomberg, $8.85 trillion dollars are currently held in cash, bank deposits and money-market funds, equal to 74% of the market value of US companies.  This represents the highest ratio of cash to market value since 1990.  Apparently, the eight previous times that cash peaked compared with the market capitalization the S&P 500 rose an average 24% in six months.  Note, however, that the rise in the S&P is dependent on knowing the actual peak, which makes this bold observation less meaningful.  The statement is similar to saying "100% of the time after the S&P reached its peak, it declined."  So while 74% seems high, who says this is the peak and that the ratio won't go to 120%?  

In theory, investors at some point will grow weary of earning 0% returns on their money, and start to dip their toes back into higher risk fare.  However, if we become trapped in a deflationary spiral, investors will have little incentive to part with their cash and return to the stock market.  So the big question remains:  Are we in for a period of deflation, as treasury yields suggest or will another bubble be stoked by the Fed's zero interest rate policy?  I am leaning towards the latter, albeit after a brief period of deflation due to asset prices over-shooting to the downside.  While I believe that some assets have already suffered significant corrections, many have not, as I will discuss in more detail in my forthcoming posts on predictions for the new year.  Certainly, the inflation versus deflation argument stands to be one of the most important of 2009, as the answer will determine if and when investors decide that stocks are worth the risk again.          

Economic Highlights and Lowlights Before the Holidays

In the good news department:

• Durable goods fell 1%, less than expected.  Excluding transportation, orders actually rose 1.2%.
• Consumer spending declined by 0.6%.  However, adjusting for a sharp drop in prices, spending actually rose by 0.6% , the first increase since May.
• Mortgage applications soared as rates fell.  The MBA reported that its mortgage application volume shot up 48% for the week ending Dec 19th.  The increase was driven by a 62.6% leap in the Refinance Index, with a weaker 17.7% increase in purchases.

In the not-so-good-news department:

• Initial claims for unemployment benefits rose 5.4% to 586,00, with the four-week moving average rising to 558,000.  Both numbers represented a 26-year high.
• The average 30-year fixed jumbo loan rate was 7.32%, significantly higher than the 5.19% average for conforming loans.  If you live in a high-cost housing area, you are not receiving any relief from the Fed's zero interest rate policy.

To summarize, the Fed's efforts to dramatically lower interest rates are reaching some consumers, in the form of lower interest rates for mortgage borrowers.  However, the news appears to only be good for those having enough equity in their homes in low-cost areas who were waiting for a good refinance opportunity.  Potential home buyers are still shying away from home purchases, most likely due to an increasingly dismal economic environment.  Although the MBA purchase index is higher, yesterday's new and existing home sales data were extremely disappointing.  Furthermore, borrowers who are upside-down on their mortgages are receiving little relief as none of the mortgage modification programs are showing signs of significant progress.  The employment picture remains weak, and the financial markets are still dependent on significant help from the Treasury's TARP.  Overall, the economic news is still relatively bleak, but with some signs of life popping up in a few indicators.

On a personal note, I wish all of my readers a very Happy Holiday season.  My posting may be on the light side for the next few days.  But if anything crazy, unexpected, and mockable occurs, I will not be stopped from writing about it.

New and Existing Home Sales Decline

Existing home sales fell 8.6% in November to an annualized rate of 4.49 million from a 4.91 million rate in October.  The median price dropped 13.2% from a year ago.  New-home sales were 2.9% lower in November to $181,300.  Inventories rose to 11.2 months' worth at the current sales pace, up from 10.3 months' at the end of October.

Meanwhile, new-home sales didn't fare much better, declining 2.9% to an annual pace of 407,000, with the median price declining 11.5% from a year earlier to $220,400.  The supply of new homes, however, fell slightly to 11.5 months' worth from 11.8 months in October.  

Clearly consumers aren't rushing out to buy homes in the face of all the gloom and doom spouted in the press daily.  Despite much lower interest rates for qualified buyers, it's hard to imagine locking into a large financial commitment when you're not sure you're going to make it through the next round of layoffs.  Or when looking at your 401K statement makes you want to vomit.  Or when you wonder how you're going to pay for your smart child's college education because his/her dream school plans to hike tuition because its endowment punted the money on "alternative investments."  Nevermind the fact that your less-cerebral child's shot at making a decent living in construction or on the assembly line at an automaker isn't looking so hot either.  So everyone is hunkering down and waiting to see what happens next.  When there is a glimmer of hope on the horizon, people will buy homes again.  Until that time, they'll be stashing any cash they can into a 0% FDIC insured account.        

Need a New Prime Broker? Call the Fed

On Friday, the Fed announced that it would offer low-cost three-year funding to any US company investing in securitized consumer loans under the Term Asset-Backed Securities Loan Facility (TALF.)  As a consequence, hedge funds will be encouraged to purchase ABS since they will have a convenient, cheap and stable financing source.  The Fed will in essence be taking on the role of a prime broker, by granting hedge funds access to leverage.  Prime brokers have been ratcheting back on the amount of leverage provided to hedge funds which has contributed to the seizing of the ABS market.  Apparently the outgoing Bush administration, in a last ditch effort to do even more damage than possibly conceivable by any twisted human being's imagination, is also considering including new CMBS (please see previous post) and RMBS.  But really, this is all fabulous news.  You see, I've been looking for a new prime broker because my current broker, for some crazy reason, will no longer lend to me at 0% without any haircut, allowing a 100-to-one leverage ratio so I can generate a 5% "risk-free" return before my two and twenty in fees.  It's just so unfair.  Thankfully, the Fed has taken my lousy prime broker's place, so my "business model" has been salvaged for now.  Can someone point me in the direction of the next bubble please?         

Developers Get in Line For TARP

Pity the poor commercial real estate developer.  Sure he made a pile of money in the boom, added a host of properties to his holdings, and probably built a bunch of buildings with borrowed money for which there is little current demand.  He may have even so far have survived the fate of his compatriots Harry Macklowe and Ian Bruce Eichner, both of whom have lost major properties to foreclosure earlier this year.  What ails him now is the prospect of roughly $160 billion in commercial real estate loans coming due in the next year without a single refinancing prospect, and approximately $530 billion within the next three years.  He can refinance, of course, at much worse terms than those he negotiated when the boom was in full force, and he will likely be forced to cough up significantly more equity to secure that loan.  But really, who wants to do that, when you can just write a letter to your buddy Hank Paulson and ask to be included in the TARP?  Sure it's the banks that own most of the CMBS that is set to implode and they have already received boatloads of cash from the government, but we want to make sure we cover all of our bases with the TARP.  Do you want your TARP funds too?  Get in line.

Minor Fraud Friday

In addition to labeling today as possibly the most boring options expiration Friday on record, I have also dubbed today "Minor Fraud Friday."  Due to the incredible and yet deserved amount of press surrounding the spectacle that is the Madoff ponzi scheme, some of the more minor recently unveiled frauds have taken a backseat in the press.  Far be it for me to discriminate against these minor frauds.  What they lack in sheer size, they more than make up for in absurdity.

Federal prosecutors and the SEC have alleged that a 35 year-old broker "stole" confidential information from his wife, a partner at a public relations firm that deals with high-profile takeover deals.  The broker then passed on the information to various colleagues, including one former Playboy Playmate, who used the inside information to generate roughly $4.8 million in ill-gotten gains.  The broker received some cash, a Cartier watch and porsche driving lessons in return for the valuable information.  Call me greedy, but I'd be asking for an actual porsche for risking my hide with maybe the driving lessons thrown in for an extra tip.  Furthermore, what is it with these pea-shooters who risk their jobs, and jail to make a measly $4.8 million?  If you're going to go for it, make it $50 million and then move to some island in the Caribbean.    

Perhaps the best little nugget in this story involves the statement by the wife's lawyer that claims she had absolutely no idea that her husband was passing on confidential information to his friends, and the aforementioned former Playboy Playmate.  The husband gained the confidential information by "being in his wife's proximity when she worked from home and knowing her schedule."  The article doesn't mention whether the wife blurted out things like:  "Guess what? InBev is going to pay $70 a share for Budweiser," while she was in the proximity of her husband but if her lawyer claims she was not complicit in the scheme, then I'm going to have to take him at his word. 

The story would be a tad juicier if the former Playboy Playmate was the broker's illicit girlfriend and the spurned wife was merely enacting revenge for his infidelity.  But alas, the Playboy Playmate was just the girlfriend of one of the traders that profited from the scheme.  Despite playing such a minor role in the scheme, the Playmate features prominently in the photo accompanying the story.  Clearly, she was the most attractive of the bunch of insider traders.  Even the Wall Street Journal has to sell papers in this tough economic environment.    

   

Banks Enabled Leverage in Madoff Scheme

What is worse than the lack of due diligence performed by the fund of funds that invested nearly all of their capital in the Madoff funds?  The banks that allowed the "feeder" funds to leverage their bets on the Madoff.  According to the Financial Times, HSBC, RBS, Nomura and BNP Paribas lent money to the fund of funds so they could lever up their investments in Madoff.  A simple ponzi scheme after all, is really nothing compared to a leveraged ponzi scheme.  These loans were ultra-safe, of course, because they were secured by "assets."  RBS (now mostly government-owned) and HSBC were extremely conservative by only allowing two-times leverage on the imaginary assets in the feeder funds.  Nomura, on the other hand, in an attempt to shirk its image as a conservative Japanese bank, allowed thrice the leverage on the underlying imaginary assets.  One would think that the banks would try to verify that some assets actually existed before going crazy with the lending.  But one would be wrong.  Little, if any due diligence was performed.  Much like the fund of funds, they were not hesitant to collect their fees, just didn't really want to work to justify them. 

GM and Chrysler Get Government Loans

GM and Chrysler will get $13.4 billion in initial loans from the government in exchange for a restructuring.  The automakers will receive an initial $4 billion in February.  The government loans will have priority over other debts and will come due by March 31st if the companies can't demonstrate financial viability by that time.  As is customary with the government bailouts, the deal is vague as "financial viability" is a somewhat nebulous condition during these highly unpredictable economic times.  Fortunately the loans come with some conditions:  The automakers must provide warrants, accept limits in executive pay, give the government access to financial records and not issue dividends.  The automakers must cut their debt by two thirds in an equity exchange, make half of the payments to a union retirement fund in equity, eliminate a program that pays union workers when they don't have work and have union costs and rules competitive with foreign automakers by December 31, 2009.  

The market likes the news, sort of.  Equity markets are marginally higher, indicating that the market was expecting the news.  Wake me up when something exciting happens.    

Lennar Loses More Money, Investors Cheer

Lennar posted a fiscal fourth-quarter net loss of $811 million or $5.12 a share.  The average analyst estimate was for a loss of $1.64 a share.  The stock is rallying nicely.  In my next life, I'd like to be reincarnated as an investor in homebuilder stocks because their perennial optimism never ceases to amaze me.  If there is any certainty in this volatile investing climate, it is that the homebuilders will always rally no matter how much money they lose in a quarter.  I find this remarkable as there is so much working against the builders.  New-home sales in the US fell in October to the lowest level in 17 years and builders broke ground in November on the fewest houses since record-keeping began.  Meanwhile, the number of foreclosures and vacant homes is rising.  Certainly the Fed has taken significant actions to lower interest rates and boost demand for homes.  But with consumer confidence at multi-decade lows and the employment picture so cloudy, people are retrenching and saving for a rainy day.  

One of the fallacies that the real estate industry likes to spread like gospel is that there is all this pent up demand from people who need to buy a home because of personal and family changes.  Nobody "needs" to buy a home, particularly not a new home.  Certainly people want to buy homes when their families expand, but they can always keep renting until they feel far more secure about their financial situation.  Just exactly when consumers begin to feel confident enough about the future to take on the stress and responsibility of a new mortgage, in addition to actually getting approved for a mortgage in this lending environment remains an enormous question mark.   

Morgan Stanley Also a Loser This Quarter

Morgan Stanley reported a $2.2 billion fourth-quarter loss, wider than most analysts expectations, yet narrower than the same quarter a year ago.  Morgan joins Goldman in proving that even with massive stimulus from the Fed and Treasury, it's impossible to make money if nobody is willing to trade, invest, or pay for advice.  

Once again, even that $2.2 billion loss is extremely optimistic, as revenue was positively impacted by a $2.7 billion gain associated with the widening of Morgan Stanley's credit spreads.  In summary:

•  The Fed has lowered interest rates to zero
•  The Fed is lending the banks money versus crap collateral
•  The Treasury handed Morgan $10 billion
•  The FDIC guaranteed its debt
  
• Morgan was able to book $2.7 billion in profit from the deterioration in its credit worthiness
• The company still lost over $2 billion

Anyone else wonder why the Fed is terrified?

The Fed is Petrified

You can read the text of the Fed's statement here.

A quick summary:

• Cut fed funds to a target range between zero and 0.25%
• Cut discount rate to 0.5%
• Will support financial markets by purchasing agency debt and MBS
• Will look to possibly purchase longer term Treasuries
• Will consider other methods to use its balance sheet to support markets and economic activity
• Labor market conditions have deteriorated, credit is strained, the economic outlook has weakened significantly
• If you can think of anything else the FOMC can do to further dump liquidity on the market, please send them a note...

Goldman Sachs Posts Loss

Remember when everyone thought that Goldman Sachs was immune to any downturn because they were just smarter than the plebian boobs working at other investment banks?  As it turns out, Goldman really is just another cyclical investment bank that can't escape the worst downturn the securities industry has seen since the Great Depression.  CEO Lloyd Blankfein's statement, after reporting negative net revenues of $1.58 billion and a net loss of $2.12 billion for the fourth quarter, summed up the situation nicely:  "Our results for the fourth quarter reflect extraordinarily difficult operating conditions, including a sharp decline in values across virtually every asset class."  The good news is that Goldman is still standing unlike Merrill, Lehman and Bear.  Even better news is that the government has shown its commitment to keeping what's left of the banking community afloat by guaranteeing its short-term debt via the FDIC, lending billions against shady collateral via the Fed, handing the investment banks capital infusions via the Treasury AND reducing interest rates to near-zero via the Fed.  So, let's just say that Goldman isn't still standing due to its own genius.  Regardless, if the investment bank makes it out of this mess alive, and the credit markets actually improve at some point within the next couple of years, Goldman will be poised to profit from the upturn.  But unlike those optimists who are currently buying the stock on this earnings announcement, I'm willing to wait until at least a small glimmer of hope is on the horizon.   

Fund of Funds Party is OVER

Contrary to popular opinion, the best job in America for the past ten years or so has not been that of a hedge fund manger.  Sure, rich people threw money at hedge fund managers, their prime broker let them lever up 50 to 1, and they could charge two-and-twenty on $10 billion in assets under management for barely outperforming T-bills.  No, the best job in America was that of a fund of hedge fund manager.  Why?  Because rich people threw money at fund of funds managers, their prime brokers let them lever up, they could charge two-and-twenty on $10 billion in assets under management for barely outperforming T-bills AND they didn't actually have to do any of the hard work entailed in trying to outperform T-bills.  What fund of funds managers were supposedly paid for was evaluating hedge fund managers and protecting their investors from potential fraud and losses in riskier assets due to a lack of diversification.  Fund of funds were supposed to be mutual funds for rich people.  Except with much higher fees.  This way, if you happened to be a grocery store magnate who had significant assets to invest, but didn't really have the time or patience to follow the market or care to hire your own private investigators to follow your hedge fund manager around, you could rest assured that you were paying someone a truckload of money to do it for you.  The fund of funds industry was founded on this principle.  It was a very clever money-making scheme.  Until Friday.

The most curious part of the Madoff Ponzi scheme pertains not to the rich people handing over their life savings to one guy without asking any questions.  Charming con men have always been able to talk the rich into parting with their cash.  What I find most amazing about this particular fraud is the unearthing of gross negligence in the fund of funds community.  So far, a fund of funds outfit called Fairfield Greenwich has announced the largest loss, that of $7.3 billion from its investment in Madoff's fund.  A $7.3 billion investment would be a perfectly reasonable allocation if Fairfield Greenwich managed around $1 trillion in assets.  But, alas, Fairfield Greenwich only managed $14 billion, having allocated more than half of its assets to one fund - a fund that was notoriously secretive, didn't have a legitimate auditor, or a separate custodian.  So I have to ask:  What exactly did the people at Fairfield Greenwich do all day?  I mean, other than calculate the fees they were earning on the phantom 10% returns that the Madoff fund "generated" for its investors?  After they performed all of that difficult and complicated due diligence that led them to believe that putting $7 billion into one fund was a fabulous investment decision, how did they spend their time at work?  They obviously weren't looking at confirms and making sure that all the returns tied out.  Did they even get statements from the firm?  From what I have read in other reports, the Madoff fund sent out statements that resembled this: "beginning balance $1 million, ending balance $1.2 million," without any further detail.  Weren't the crack investigators at Fairfield interested in a little bit more detail about how their returns were generated?  I am not casually throwing the term "investigator" around either, for one of the founders of Fairfield Greenwich was a former enforcement officer with the SEC, which perhaps explains why the SEC didn't unearth the ponzi scheme before Mr. Madoff's sons turned him in.    

Fairfield was not the only fund that perpetrated such negligence in its asset allocation decisions for clients.  Several other funds are on the list of offenders that had inexplicably large allocations to Madoff, with a few allocating ALL of their assets.  Did the managers of these fund of funds really think that their laziness and complacency was worth the multi-million dollars in fees that they collected?  Certainly their investors don't anymore.  Most of these funds will be sued to high heaven as investors go after refunds of fees collected on profits that never existed.  They won't survive and the founders will be tied up in a mass of litigation for years.  Furthermore, the fund of funds redemption game will begin anew.   

      

Madoff Fraud Exposes Regulatory Weakness

How do you perpetrate a $50 billion ponzi scheme?  The details are still hazy, but a few clues that something was amiss at Bernie Madoff's investment fund were enough to keep at least one shrewd advisor from steering clients into the massive fraud.  An advisory firm named Aksia, attempted to replicate the "split-strike conversion" strategy, using a quant analyst who failed to reproduce the returns indicated by Madoff's fund.  Furthermore, since all of the firm's assets were custodied with Madoff Securities, rather than a third-party clearing firm, Aksia investigated the auditor Friehling & Horowitz.  F & H only had three employees, one of which was a 78 year-old living in Florida, one secretary and one active 47 year-old accountant.  The office was in Rockland County, NY and was only 13ft x 18ft large.  Given the scope of Madoff's investment operation, the auditing firm appeared small.  Why other advisory firms and fund of funds firms didn't perform the same due diligence remains a mystery.  After all, what purpose do all of those extra fees on top of fees serve if not to fund extensive due diligence?  It is remarkable how many wealthy and sophisticated investors forked over money to Mr. Madoff given the lack of transparency.  Furthermore, it is even more incredible that some very wealthy investors were so enamored with Mr. Madoff that they handed their entire net worth over to one fund.  The Wall Street Journal has several interesting articles covering many of the issues raised by the Madoff debacle.  The victims of the fraud included many well known wealthy investors and Jewish charities.  Furthermore, an entire enclave in Palm Beach where Mr. Madoff recruited investors has been decimated by losses, with four ultra-luxury condos hitting the market this weekend in one resort, and investors calling the local high-end pawn shop on a Saturday (when it is ordinarily closed) to get loans. 

Where exactly was the SEC?  Asleep at the switch again.  According to the Wall Street Journal, the SEC investigated the firm several times over the years and came up empty-handed.  The agency's enforcement division even investigated a whistle-blower's concerns in 2007, but closed the probe without bringing a case.  Additionally, Mr. Madoff registered his firm as an investment advisor in September 2006 and was not examined within the first year, as is the  requirement for new investment advisors.  The SEC did not sue until December 11, 2008 when Mr. Madoff's sons turned their father in after his confession.  Clearly, there is something very wrong with the regulatory structure of the US securities industry if it cannot unearth a scheme this large without a confession from the guilty party.  The fact that this monumental scam went undetected for so long is mind-boggling and will be a tremendous blow to the hedge fund industry.  Make no mistake, if investors were scrambling to get their money out of hedge funds before the Madoff fraud was unveiled, redemption requests will only increase significantly on the heels of this news.  Analysts who have been calling for the industry to shrink by 30-40%, will have to revise their estimates much higher.  Try 70%.  That's if they can get around the "gates."    

Automaker Bailout Falls Apart in Senate, Grab Your Helmets

The Senate put the kibosh on the $14 billion temporary bailout of the U.S. auto industry.  Of course, the temporary bailout was merely a stopgap measure to keep the car makers operating until a more permanent bailout solution could be concocted by the new administration.  What held up the bill?  The sticking point was how soon union employees' pay should be adjusted to parity with employees of nonunion workers' at plants operated by foreign automakers in the U.S.  The Republicans wanted to reach parity in 2009 and the Democrats wanted more time because, according to Sen. Dodd, with the economy in recession, he thought it wouldn't be fair to force auto workers to accept wage cuts in 2009.  Apparently, he thinks it's completely reasonable for a bunch of autoworkers to be unemployed during the worst recession this country has seen in decades.  Without government aid, both GM and Chrysler will file for bankruptcy before the end of the year.  Wave goodbye to what remained of the U.S. manufacturing industry because once the companies go into Chapter 11 bankruptcy, it seems unlikely that they will emerge.  Unless the government is willing to provide DIP financing, they're headed straight for Chapter 7 liquidation, which is great news if you're in the market for a cheap manufacturing plant in Michigan.  Bad news if you happen to live in the Midwest, because the economy is likely to head straight into the toilet.  Although I suppose all of those out of work auto employees can just go work for AIG.  Maybe they can line up a $3 million bonus just for showing up for work.  

I'm not placing the blame solely on the Democrats, of course.  The Republicans didn't support the rescue package because of "concerns about government intervention in the marketplace."  You see, according to the Republicans, it's perfectly okay to intervene in the marketplace as long as you are keeping insolvent financial institutions afloat (i.e. AIG, Citi, Mer) and supporting bonuses for Wall Street employees.  Blue collar union employees are a whole different story.  Amazing, yet not surprising, where our legislators decide to draw the line.    

The market, of course, is officially back in panic mode.  Futures are off significantly, as investors understand that the repercussions of a bankruptcy of the Big Three will be spread far and wide.  If you thought we were out of the woods, you were sadly mistaken.  

 

RIP BCE Buyout

I must admit, I'm somewhat sad to see the BCE buyout officially fall apart.  Witnessing the litigation circus that this deal morphed into has been extraordinarily amusing.  Why the private equity group, led by the Ontario Teachers' Pension Plan of all people, was so dead-set on completing a monster deal struck at the peak of the private equity boom remains a bit of a mystery.  Perhaps the Ontario Teachers have no business investing in private equity if they are so lousy at assessing such a stark change in the investment environment?  Or perhaps, they're smarter than we think?   

In a surprising twist, the deal was killed by a solvency, or rather lack-of-solvency opinion issued by the firm's auditor KPMG.  What do you do when your auditor tells you the firm will be insolvent if the deal goes through?  You try to find another auditor to express an alternate opinion!  BCE engaged Pricewaterhouse Coopers, which delivered a positive solvency opinion.  Because it is really reassuring to know that at least one out of two auditors think the firm will be solvent.  You definitely want to base a multi-billion deal on that.  In any event, the true irony is that BCE originally inserted the solvency-certificate condition in the merger agreement as a condition of closing to protect itself from  lawsuits by existing BCE bondholders, who were pissed about the company's proposed new debt-laden capital structure.  The negative opinion killed the deal, and all involved are certainly rejoicing, with the exception of BCE and its shareholders, who would love a $34-a share take-out, with the stock currently languishing at $18.

With the auditing industry famous for putting its stamp of approval on stellar outfits such as Enron, Worldcom, Bear Stearns, Lehman Brothers and a host of other companies that were basically insolvent and went bankrupt with nary an auditor raising a flag, I've got to ask the following controversial question:  Who bribed the auditors into killing the deal?  I'm not going to point any fingers because my conspiracy theories are purely a figment of my overactive imagination, but I have a few ideas... 

 

Economic Headlines

Investors have plenty of data to chew over while the Senate takes its sweet time debating the automaker bailout.  First the bad news:

• Weekly jobless claims soared by 58,000 to a seasonally adjusted 573,000 versus analyst forecasts of 525,000 in the week ended December 6, 2008.  The four-week moving average rose to 540,500, the highest since December 18,1982. 
• Both exports and imports declined in October, but the overall deficit rose as the volume of oil imports spiked.  The trade deficit widened 1.1% to $57.2 billion versus consensus estimates from economists of a narrowing of the deficit to $54.5 billion.
• Retail sales were down 5.5% in November, and on-line sales were about flat from the previous year.
• Credit card charge-offs  are poised to rise significantly from the 6% rate reported in the third quarter.  Card industry executives have seen escalating "roll rates", the percentage of cardholders who go from late payments to not making payments at all.  Among cardholders who are between 60 and 89 days overdue, about 20% are being charged off as uncollectible, up about a third from last year.

In the deceptively good news department:

• Foreclosure filings dropped 7% from October to November but rose year-over-year 28% to 259,085.  The decline is being attributed to several moratoriums on foreclosures instituted by Fannie, Freddie, and other major lenders.  The numbers are expected to continue rising once the moratoriums are lifted.

AIG: You Cannot Be Serious!

Presented without comment because I'm officially speechless:

AIG facing another $10 billion in previously undisclosed losses on "speculative trades."  Details to come.

AIG handing out cash retention bonuses between $92,500 and $4 million to employees earning salaries between $160,000 and $1 million. 

Can it Get Any Worse For Cerberus?

While lawmakers were busy attempting to hammer out a bailout plan for the automakers, somebody looked up, scratched his head, and said "Wait a minute, isn't Chrysler owned by a private equity firm?  Don't we hate those guys for contributing to the credit crisis by piling on debt to cyclical companies, laying off employees under the guise of "efficiency" and then driving them to bankruptcy because they didn't really know what they were doing and it was just a bubble?  Don't we also hate them for paying themselves all kinds of money and getting favorable tax treatment?  Wait a minute!  Didn't they hire John Snow, a guy who was so bad as the Treasury Secretary that he was forced out by the worst President in the history of the US?  More importantly, isn't Dan Quayle on their payroll????!"  Bailing out the public automakers, GM and Ford, that have been shut out of the capital markets is one thing.  But why should the government bailout Chrysler, privately owned by the three-headed dogs at Cerberus?  Don't the dogs have loads of capital that they can inject?  Details of the bailout plan will be forthcoming, but I hope Cerberus is at least required to pony up some cash alongside the government.

In other Cerberus Sucks news, GMAC's application to become a bank holding company was denied due to insufficient capital.  GMAC is attempting to complete an old-crappy-debt-for-new-crappy-debt swap to restructure. Again.  After the last restructuring didn't work.  So far, only 25% of investors are going for it.  Without the debt swap, the company's prospects are not looking so hot.  Apparently, there are only so many financial engineering tricks investors are willing to fall for before they throw in the towel and decide to take their chances in bankruptcy court.  Did Cerberus really think that guarding the gates of hell would be easy? 

China Growth Machine Hitting the Wall

China's exports and imports both shrank unexpectedly in November.  And by "unexpectedly," I mean "Holy cow! Fire the economists!."  Exports fell 2.2% from a year earlier, compared to expectations of a rise of 15%, while imports dropped by 17.9% compared to expectations of a rise of 12%.  China was widely anticipated to buck the global credit and now economic crises, by continuing to grow, albeit at a slower pace.  But it looks like that isn't going to happen, despite the Chinese government's plan to spend 4 trillion yuan ($586 billion) to boost infrastructure spending and its move to slash interest rates to stimulate the economy.  A slight weakening in the yuan allowed by the government last week raised eyebrows and caused many to speculate that the government would move to depreciate the currency further to help boost exports.  Make no mistake, if China's economy starts contracting significantly, the rest of the world is in big trouble.  We were depending on China to grow us out of this mess. If they aren't going to do it, who will? 

Rescue Plan For the Credit Unions?

If you thought the automaker rescue plan was the only one in the works, think again.  According to the Wall Street Journal, federal regulators are preparing a rescue plan to shore up the finances of some of the large credit unions.  The plan will tap the $41 billion lending facility that Congress made available to credit-union regulators in September.  Apparently, corporate credit unions are reeling from paper losses (i.e. probably real losses by now) on MBS.  The Chairman of the National Credit Union Administration (NCUA) is not calling the lending facility a taxpayer-funded bailout.  It is instead a short-term "mechanism to stabilize the credit-union system" while regulators work on other steps (i.e. the actual taxpayer-funded bailout.)  A related program also to be announced by the NCUA will provide $2 billion in inexpensive loans to credit unions to reduce mortgage interest rates for homeowners.  

What are corporate credit unions and who cares about them?  Here is the WSJ's quick description:

"Credit unions are member-owned cooperatives that act much like banks, taking deposits and offering loans. At the end of last year, there were about 8,400 credit unions in the U.S. with $775 billion in assets. Most are faring fine financially.

The rescue plan is aimed at shoring up the network of corporate credit unions, which are wholesale-style institutions that provide financing, investment and clearing services to retail credit unions. The retail credit unions are cooperative owners of the corporate credit unions.

As part of their role, corporates take deposits from retail credit unions, then invest that money in longer-term assets. But some of the largest corporates invested in mortgage-backed securities, and lately have suffered paper losses."

So, really, no need to worry about the retail credit unions.  They are faring fine.  The problem is that they all rely on the corporate credit unions, which are apparently blowing out. Retail credit unions are pulling deposits exacerbating an already difficult situation for the corporates. The stabilization plan to be announced has two steps:

• Retail credit unions borrow from a lending facility at a favorable rate (1.5%) and then deposit that money with a corporate credit union with a federal guarantee and a small additional rate of return.
  
• Retail credit unions borrow up to $2 billion at a favorable rate (1.25%) and use the money to subsidize interest-rate relief for troubled homeowners.

Mind you, these are temporary financing measures that don't address the capital issue.  Perhaps a new administration will be more willing to help the plight of the credit unions as Hank Paulson chose to exclude them from the TARP.  A chart from the Journal depicts the mounting losses at the largest corporate credit unions:  

FedEx, TXN Spoil the Market's Party

A string of several positive days for the equity markets has nudged all the bottom-callers out from under their desks to confidently proclaim yet another bottom.  Unfortunately, they have been smacked in the face this afternoon by the official start of pre-announcement season.  Both FedEx and Texas Instruments pre-announced worse-than-expected earnings.  While FedEx said it expected to meet second quarter earnings estimates,  the company sharply lowered guidance for fiscal 2009 from $4.75 to $5.25 share to $3.50 to $4.75 a share.  

Meanwhile, in Techland, Texas Instruments said it expects fourth quarter earnings of $0.10 to $0.16 per share, and revenue of $2.30 to $2.50 billion.  The chip maker's prior estimates called for earnings of $0.30 to $0.36 a share and revenues of $2.83 billion to $3.07 billion a share.  Shares in FedEx are down roughly 11%, while Texas shares are off 3% in after hours trading.  Can the market sustain yet another rally tomorrow in the face of such sobering news from two important companies?  If we get a government bailout of the auto industry tonight, maybe.  But I wouldn't hold my breath if I were you.

Tribune Files For Bankruptcy, Fitch Downgrades Debt

In a widely anticipated move, Tribune filed for Chapter 11 bankruptcy protection this afternoon.  Despite the many headlines in the morning warning of a likely bankruptcy filing by the newspaper outfit, the crack analysts at Fitch waited until AFTER the bankruptcy filing to downgrade the company's debt.  Furthermore, the crack reporters at Market Watch reported the Fitch downgrade as if it was relevant news.  Because somewhere an investor must care that the bonds he holds of a now-bankrupt company have been downgraded to 'D' from 'CCC.'  Mock the Market's new rating for Fitch? F-!   

Wagoner Pressured to Resign, Thain Looking for Bonus

The front page of the Wall Street Journal rarely crackles with irony as much as today.  Clearly it was a fairly slow news day when two of the top stories revolve around CEOs.  Senator Chris Dodd is calling for Rick Wagoner's head (figuratively) if the government follows through with the billions in loans that GM has requested.  Meanwhile, in a separate, yet somehow completely related story, Merrill's John Thain is tussling with his board over a $10 million bonus, which he claims he deserves.  Mr. Thain believes that he saved the firm from imminent collapse by selling the company to Bank of America.  For this Herculean feat he is asking his (shocked? appalled? incredulous?) board for $10 million in comp.  I still firmly maintain, as I've stated many times before, that selling Merrill to B of A is not what averted the investment bank's collapse.  Sure, it was a shrewd move.  What saved Merrill was billions upon billions of financing from the Federal Reserve through a variety of new and unprecedented lending facilities, in addition to billions in direct capital injections from the Treasury.  Merrill's survival is due to actions by Ben Bernanke and Hank Paulson, not John Thain.  If Merrill's board is going to write a check to anyone, it should be to those two.      

Again, it is interesting that our lawmakers are even hesitating for a moment about helping the auto-industry, given how easily they showered their largesse over the banking system.  Furthermore, it is a bit hard to stomach that the bailouts were handed out to banks without any restrictions on dividends and pay.  The fact that Merrill's CEO is even thinking of asking his board for compensation in these politically charged times is unbelievable.  Even the heads Goldman Sachs, a firm that actually made money this year instead of losing billions like Merrill, gave up compensation.  Mr. Thain is demonstrating that what he lacks in common sense, he more than makes up for in cojones.    

Update:  The Wall Street Journal is reporting that Mr. Thain met with Merrill's board and will be passing on a bonus this year.

Ugly Employment Report

The US shed 533,000 jobs last month and the unemployment rate hit 6.7%.  This is the worst employment report I have ever witnessed and indeed the US hasn't lost jobs at this pace in over 30 years.  163,000 of the job losses came from the goods-producing industries, with manufacturing firms cutting 85,000 jobs.  Construction employment was down 82,000 and the service-sector lost 370,000 jobs.  If that weren't enough, the prior month was revised down from 240,000 to 320,000 job losses.  Unsurprisingly, the market is unhappy with these numbers as it confirms that the current recession we are in will be incredibly painful.  Hopefully, our lawmakers are paying attention and can find a way to keep the US auto industry out of Chapter 11 (unless it is a government financed pre-pack) as the loss of our manufacturing sector would be devastating.     

Treasury Working on Another Mortgage Scheme

The Treasury Department tested out another mortgage scheme, concocted in a panic, by leaking it to the press.  The plan is aimed at "revitalizing the US home market."  Details are sketchy, but it has something to do with lowering mortgage rates to 4.5% for buyers who can qualify for a conforming loan from Fannie and Freddie.  Only those who can document their income, and afford the monthly payments will qualify.  The fact that the Treasury has to make the clarification that people who cannot afford a mortgage will be excluded from the plan, gets to the heart of the Treasury's problem.  It is why, so far, no program that lawmakers have initiated has accomplished much more than averting a total collapse of the financial system.  In every speech I have heard Mr. Paulson deliver, he continues to stress that the root of the credit crisis is the correction in the housing market.  Sure, the correction in home values has caused significant damage, but it is merely a symptom of the real disease, which Mr. Paulson has completely misdiagnosed.  The root of the credit crisis was a period of lax lending and stupidity by the credit markets, where standards for lending versus all sorts of assets were lowered to unsustainable levels.  Easy lending led to inflated asset values which were not supportable by fundamentals.  This is precisely why the commercial real estate market is also collapsing, because buying properties for a 2.5% cap rate, which was customary in heated parts of the country, is moronic.  It does not make financial sense when you are borrowing at 6.5% to finance the purchase and putting in little equity.  Asset values are now in a free-fall and they aren't going to stop declining until the fundamentals make sense for buyers.  Sure credit is tight right now, but a credit-worthy person who can put 20% down and can afford the monthly payments can get a mortgage.  Maybe the government should stop trying to prop up housing values with crazy financing schemes, and just start buying houses in bulk at huge discounts from banks's REO departments, do slight renovations, and convert them into housing for veterans, or poor people.  Sounds crazy, but possibly not any crazier than anything else that has been proposed.     

Hedge Funds Overwhelmed by Redemption Requests, Uh Oh

Speculation has mounted in the past month about the number of hedge funds that would be forced to close their doors due to poor performance.  Hedge funds were supposedly bracing themselves for record redemption requests from investors by hoarding cash.  Noted hedge fund managers, such as George Soros, were making dire predictions about the industry shrinking drastically.  Now that the year-end is upon is, it appears as if the shrinkage may have been understated.  The past couple of days have been littered with headlines announcing that large hedge funds had halted redemptions due to an overwhelming amount of requests for capital withdrawals.  What's even more curious is that hedge funds with relatively decent performance have had to act to halt redemptions in order to keep from penalizing the investors that wish to stay in the fund.  Yesterday's announcement by Tudor Investments of its intent to halt redemptions was a bit of a surprise.  Tudor investments was only down 5% so far, a screaming outperformance of just about every single asset class with the exception of John Paulson (Paulson is his own asset class.)  Redemptions in Tudor Investments were halted so that the firm could avoid having to dump all of its liquid assets and leave its loyal investors holding a bunch of illiquid crap.  Perhaps the securities were liquid at some point, but not anymore, which begs the follow-up question: Is the fund really only down 5%?  

Today brought a string of similar headlines from hedge funds.  Fortress halted withdrawals from its global macro fund after it received requests for $3.51 billion, or nearly 50% in withdrawals.  The Fortress Global Macro Fund might ring a bell to my regular readers.  Back in August, I wrote about the manager of that fund receiving a $300 million share grant from Fortress, to keep him from leaving when the fund was already down 12% on the year.  Equity holders in FIG who may have been irritated at being so heavily diluted just to keep someone "motivated" can at least take some comfort in the fact that his $300 million grant is worth a heck of alot less today.

Dealbreaker had post after post today of funds posting lousy performance numbers and announcing halting of redemption requests, names including Farrallon and Highbridge, two of the largest and most well-respected funds in the hedge fund community.  I shudder to think of what we're going to hear in the redemption department from Citadel, which was already down nearly 40% on the year.  

All of this frantic pleading for a return of capital makes me ponder who wants their money back and why?  In particular, why all the redemption requests from funds that have performed reasonably well?  The obvious suspects are the pensions and endowments that have contributed to the hedge fund boom of recent years by increasing allocations towards alternative investments.  Clearly they are getting killed and need to raise cash to meet obligations as the value of all of their investments has fallen across the board.  If that is the case, then really, the hedge fund redemption frenzy will probably be over by year end.  Lots of shops will close, and those that are still standing will be able to buy assets on the cheap.  What concerns me is that the answer is far more ominous.  It's possible that many of the redemption requests are coming from rich people who are blowing out.  One of the things about this downturn that has been somewhat interesting is the number of very wealthy people that have been forced to liquidate stock holdings because of excessive personal leverage (Sumner Redstone and the CEO of Chesapeake to name two that come to mind.)  While it may be the case that wealthy investors are pulling money from hedge funds because they are worried about the market and the economy, it may also be the case that they really need the money.  Perhaps they got a little over extended, they have loans to repay, can't sell any one of their houses, have watched their stocks crater, have contemplated selling the family jewels, and frankly, they just NEED SOME CASH.  I suspect that a nice Fannie Mae conforming loan with a 4.5% interest rate is not even going to begin to solve their problems.          

       

Merrill Lynch Has Trouble With Math

A Bloomberg story this morning claims that Merrill Lynch is said to be cutting bonuses by 50% this year.  I'm sure that headline was meant to be eye-catching, so that readers are shocked by the huge haircut Merrill's bankers will be forced to stomach.  What caught my eye, however, was the fact that Merrill's revenues dropped 96% in the nine months ended September 2008 from a year earlier.  Investment banks generally pay out 50% of revenues as compensation.  Something about the math here doesn't really add up.  Revenues shrink by 96%, the firm loses over $20 billion, nearly fails, and is forced to merge and get various bailouts from the government.  Yet somehow, Merrill is only reducing bonuses by 50% from last year, which was a record year for pay?  The article clarifies that bonuses account for the bulk of a year's pay for most traders and investment bankers.  While that is certainly true, we are talking about people who have base salaries of $150,000 or so, and then receive bonuses of like $650,000.  Let's not be mistaken that anyone here is working for commissions alone.  So while our lawmakers argue over putting GM out of business, the recipient of $10 billion in cash from Mr. Paulson and multiple billions in loans via Mr. Bernanke, is busy handing out bonuses.  Nice.    

AutoMakers Plead For Government Funds: Take Two

Today was a very good day to make a case that the US auto industry needs a government bailout. November car sales were flat-out horrendous.  Even Toyota had a year-over-year decline in sales of 34%.  Ford outperformed the competition with a mere 31% drop.  GM saw sales plunge 41% and Chrysler won the prize for worst sales performance by an automaker with a wrenching decline of 47%.  Overall, the industry sold about 34%, or 400,000 fewer vehicles, in November 2008 than it did a year ago.

Both GM and Ford presented turnaround plans to Congress today.  GM requested a total of $18 billion in federal loans, stressing that it needed an immediate injection of $4 billion to stay afloat until the end of the year.  GM's situation is the most precarious as it will likely be forced into a Chapter 11 bankruptcy filing before Christmas without government funds.  The automaker began discussions with bondholders in an attempt to cut its debt load by $30 billion by swapping debt for equity in GM.  GM will also attempt to restructure obligations to a UAW health-care trust set to begin paying benefits to retirees in 2010.  Nevertheless, the company stated that it didn't have a "Plan B," and was depending on help from Congress.

Ford is in much better shape, primarily due to the fact that it borrowed every penny it could raise in 2006 before the credit markets fell apart.  Ford is only asking for a $9 billion credit line, in the event that the recession is longer and deeper than expected.  Ford estimated that it would return to profitability by 2011 and planned to accelerate the development of new hybrid and batter-powered vehicles.  Of course, with the price of gas plummeting every day due to the commodity rout, by the time the vehicles are completed, everyone is going to want to buy a Hummer again.  Because when you're living underground in a bunker with your canned goods, and your bars of gold (wondering what the hell they're good for) and you have to go out for groceries, it's going to help to have a Hummer handy.  You'll be using the electric car as a toaster.  

Weak Earnings, Economic Data Haunt Market

Although equity futures are higher in pre-market trading, most of the earnings releases this morning are marginal, at best.  Yesterday was a brutal day for the market, with all indices down sharply.  The day began with China reporting a steep decline in manufacturing and ended with Bernanke admitting he was ready to initiate Japanese-style monetary policy.  As a quick aside, is anyone else perplexed by the Fed's announcement to purchase long term treasuries during a period when it needs to be issuing all kinds of treasuries to finance these purchases?  I'm not an economist, but perhaps someone can explain how this makes sense.  Why not purchase corporate debt and fund it with treasuries?  Aren't widening spreads and risk aversion the real problem?  But I digress.  Back to the headlines:   

• Sears swung to a larger than expected loss of $146 million.  Revenue declined 7.8% to $10.7 billion.  The company will close more stores and continue buying back stock. Great idea!  Because all of that stock that Sears paid $135 for last year in its buyback program has worked out really well for them.
  
• Staples third-quarter profit fell 43% on costs to acquire Corporate Express.  Revenue rose 34% to $6.95 billion, but declined excluding the acquisition.
• GE announced that profits at its GE Capital finance unit will decline to $8 billion this year, and $5 billion in 2009, lower than previous guidance.  Profit excluding charges at GE Capital will be around $9 billion, as forecast.  The company plans to keep the $1.24 dividend in 2009 and protect its AAA credit rating.  It seems highly unlikely to me that it can do both and I suspect that the dividend will have to be cut at some point down the line.
• Beazer Homes posted yet another loss and a sharp decline in revenues.  The company wrote down deferred tax assets by $398.6 million, indicating that it had no plans to ever make money again.  The builder reported a net loss of $473.9 million or $12.29 a share.  Revenue decreased 35% to $712.6 million.

With news like this, it seems hard to imagine that the indexes can muster more than a anemic rally.  Although, in a crazy volatile market such as the one we're stuck with, anything is possible.

Exotic Illiquid Investments Losing Luster With Pensions, Endowments

According to the Wall Street Journal, The Pennsylvania state employees' pension fund may be forced to make cash payments of $2.5 billion or more to Wall Street trading partners, due to investments in a "complicated" strategy referred to as "portable alpha."  Portable alpha is basically a leveraged bet on hedge fund performance.  An investor buys derivatives to match the market's return (the beta) and then uses the excess cash to invest in hedge funds (the alpha.)  According to the Wall Street Journal, an estimated $75 billion or more has been invested using portable alpha, with pension funds being eager players.  This strategy worked brilliantly from 2003-2006, as did pretty much any investment in anything during the bull market.  Leverage in a bull market is fantabulous.  Those who weren't around during the Long Term Capital kerfuffle in 1998 just recently learned: leverage in a bear market is deadly.  What has contributed to the deadliness of this credit market blow-out is the use of leverage to enhance returns on illiquid investments.  It's one thing to borrow a bunch of money to buy stocks or plain vanilla bonds.  The market goes down, you are forced to sell your stocks and bonds to repay your debt and it's over.  You're out of business but it's a pretty quick hit to the market.  However, stocks and bonds are fairly liquid.  What happens when you are leveraged and invested in illiquid assets, such as private equity funds, hedge funds, land, and oh, I don't know, timber?  Now you have a big problem.  Maybe you thought your hedge fund was liquid, but, um, no, now that it has frozen all redemptions due to the fact that it is down 65% for the year, and it was invested in all kinds of crap you never understood; not so liquid.  Your private equity fund?  Oh yeah, those guys have been in the business for years, everyone is clamoring to get into that fund because it's so prestigious.  I'm sure I can just sell my stake in the fund to someone else who really really believes in the Chrysler, GMAC, Freescale [insert name of highly cyclical company taken private at the peak of the economic cycle and loaded up with debt] turnaround story.  Except that, um, maybe not.  Because, you see, Harvard and a host of other investors who used to have a long investment horizon are now rushing to sell those stakes too at discounts of over 50%.  Also in line to punt private equity stakes are AIG (must repay government loan) and Lehman (must finish liquidating to complete bankruptcy process.)  The problem is; too many people rushing for the exits, and far too few lined up to buy either because they can't or because they believe that even a 70% discount is a crappy deal.

Investors have learned a very hard lesson in the past year.  The common refrain pitched by Wall Street to investors with supposedly long time horizons was that the extra yield offered by less liquid investments was worth the risk of tying up your money in assets that weren't easily redeemable.  Unfortunately, investors didn't demand enough of a premium for liquidity risk.  Now that they need the money, they are paying the price by having to sell their stakes at huge discounts.  What this has created is a yawning divide in the price between liquid and illiquid assets that, frankly, should've always existed.  Sure stocks are down around 40% on the year.  But many hedge funds are down more, and if they've frozen redemptions, good luck ever getting your money back.  Hedge funds have turned out not to be liquid investments.  Private equity funds don't have to mark to market, but given the lack of an exit strategy for most of their investments, they are facing a much longer time horizon than expected to reap any returns.  The time horizons, of course, will be shortened when a host of firms that were recent leveraged buy-outs go bankrupt because they were terrible investments. 

Given the horrible returns that pensions and endowments are certain to post this year, there will be a huge backlash towards the alternative investing that has been the rage for the past several years.  Risk premiums will return to more realistic levels without everyone chasing after the same investment strategies.  Ultimately, extraordinary investment opportunities will abound for those willing to take the risk.  Investors who have patiently sat on the sidelines for years because they didn't believe all the hype, will be in a position to cherry pick from a variety of investment options offering significant returns.  Fees for hedge funds and private equity funds will be reassessed and reduced significantly.  The alternative investment party is finally over.      

Economic Data to Go With Your Turkey

In honor of the impending Thanksgiving Holiday, I have vowed not to insert the words "the worst level since [pick a year that was a long time ago]" after every economic number I report.  Instead, I will report the facts followed by some commentary.  First the bad news:

• Durable goods orders dropped 6.2%, September's number was revised down from 0.9% to 0.2%.
• Consumer spending declined 1%, with personal incomes rising 0.3%.
• The Chicago ISM business index declined to 33.8 (a number below 50 indicates contraction.)

In the marginally good news department:

• Jobless claims fell to 529,000, but the four-week moving average rose by 11,000 to 518,000.

In the potentially really good news department:

• Mortgage interest rates fell dramatically yesterday on the heels of the Fed's announcement that it would purchase $600 billion in GSE direct debt and MBS.  This is great news for anyone looking to refinance or purchase a home.  The Wall Street Journal reported anecdotal evidence of a surge in refinancing efforts yesterday.  We'll see the actual data when the MBA refinance index is reported.

Yesterday's economic data pointed to continued declines in home prices via the Case-Schiller index, which showed that prices were off 16.6% year-over-year in the third quarter and 21% from the peak.  Third quarter GDP was revised down from an initial estimate of 0.3% to 0.5%.  Also, the FDIC reported that the number of problem banks increased to 171 from 117 in the quarter.

In summary, the economic data is very weak.  But, the Fed and the Treasury have put the printing presses in high gear, hoping against hope, that we might avoid a horrible deflationary spiral, like Japan in the 90's.  Then, if we make it out of the deflationary spiral, perhaps they will start to deal with the potential inflationary spiral they have created from all the money printing (such as [pick your favorite Latin American country].)  Economic experts are weighing in everywhere with their opinions about the unintended consequences that will result from the clear path of quantitative easing (like what Japan did in the '90's) that we are on.  

I'm certainly no economist, but I too believe that the unintended consequences of the Fed and Treasury's actions will be many.  Maybe some brilliant economist has predicted what they will be, but nobody knows for certain and surprises will abound.  Perhaps the most interesting part of all of this so far is that despite everything the Fed has done to devalue our currency, investors still view treasuries as the safest investment in the world.  All of the dire predictions about foreign central banks abandoning US treasuries and pushing our interest rates to double digit levels have not come true.  Remarkably, during a period of time when the Treasury is auctioning enormous amounts of debt to fund all of the bailouts, investors are snapping it all up and requiring virtually no return on their investment.  The market is desperate for US treasuries.  Gold hasn't rallied to $3,000 an ounce.  So, what's the story?  Why are investors still believers in the US?  I suspect because the alternative is too grim for any of them to fathom.  A reshuffling of the world financial order, where the full faith and credit of the US is considered a worthless promise, is not something investors are ready to contemplate yet.  That should certainly give every worried American something to be thankful for this holiday season.  On that note, I would like to wish my readers a very Happy Thanksgiving.  

Fed Throws $800 Billion More At Credit Markets

The Fed initiated yet another lending facility called the Term Asset-Backed Securities lending Facility (TALF.)  The TALF will lend up to $200 billion on a non-recourse basis to holders of certain AAA-rated ABS backed by newly and recently originated consumer and small business loans.  The Treasury will provide $20 billion of credit protection to the Federal Reserve Bank of New York in connection with the TALF.  This new facility is aimed at freeing up lending in the consumer and small business loan arena, and should help companies like American Express who were begging for TARP funds because the ABS market had essentially shut down.  

Additionally, the Federal Reserve announced this morning that it would purchase as much as $600 billion in debt issued or backed by GSE's.  The $600 billion will be broken down into $100 billion in direct debt of Fannie, Freddie and the Federal Home Loan Banks and $500 billion in MBS.  The direct debt will be purchased through auctions from primary dealers, while the MBS will be purchased from asset managers to be selected via a competitive process (i.e. PIMCO)

These programs are aimed at alleviating the continued pressure in the credit markets that have forced spreads to widen to unprecedented levels.  Consequently, despite the Fed's easing to a 1% fed funds target, borrowing rates for consumers on mortgages and other types of debt remains stubbornly high.  Will this work?  Who knows?  Bringing down the cost of mortgages was the initial goal of putting Fannie and Freddie into conservatorship, and that didn't seem to go too well.  Furthermore, I'm not sure if it's just my twisted sense of humor, but I find it hilarious that the Fed is buying GSE debt.  The government already owns the GSEs.  So, the government is basically buying debt from...itself.  Why this should tighten spreads further is a mystery to me, but it will probably work in the short term.  Much like yesterday's announcement of the Citigroup bailout, a detailed outline of how losses would be allocated to each government entity had me in hysterics.  In the end, does it really matter if the FDIC or the FED takes the hit?  It's ultimately all going to come out of our pockets.       

US Government Bails Out Citi, Who's Next?

After much see-sawing and several leaks to the press on Sunday, the government finally reached an agreement to bailout Citigroup.  The terms of the deal include splitting the bank's assets into a "good-bank/bad-bank" format.  Alas, the government will be guaranteeing the assets in the "bad bank" as well as administering spankings when appropriate.  The outline of the terms of the deal can be found here, but here are a few highlights:

$306 billion in bad assets will be "ring-fenced" in the bad bank.  Citigroup will absorb all losses up to $29 billion in addition to existing reserves.  Beyond $29 billion, the losses will be split, with the government taking 90% and Citigroup absorbing 10%.  For anyone who actually cares which of the institutions will be bearing the loss, the government has broken this out as well.  Although ultimately it is all coming from the same kitty, the breakdown matters because investors need to know how much is left in the TARP for other beleaguered institutions.  The US Treasury will absorb the first $5 billion, followed by the FDIC with $10 billion, with the Fed on the hook for the balance as it will be financing the debacle with a non-recourse loan at a rate of OIS plus 300 basis points.

What is the government getting in return for assuming all of this risk?  Citi will issue $7 billion in preferred stock with an 8% dividend rate.  However, Citi will retain the income stream from the guaranteed assets insuring that the government's investment has little upside and enormous downside.  Citi will be prohibited from paying common stock dividends for three years and, of course, compensation of executives will need to be approved by the government.

Frankly, this is a fantastic deal for Citigroup and a really lousy one for the government.  The maximum downside to the government on this deal is $209 billion.  Certainly that is if the assets go to zero, and nobody measures risk that way, blah blah blah.  But a failure of risk managers to consider catastrophic losses as a possibility is what got Citi in this mess to begin with.  The original purpose of the TARP, to purchase toxic assets from banks, has been revived, but apparently only for Citigroup.  I suspect that the market is going to continue punishing the stocks of all the banks, until the government agrees to do the same with any institution it deems as holding too many crappy assets.  Does this sound like a crazy conspiracy where the banking industry attempts to cannibalize itself in order to force the type of government bailout it wants?  Absolutely.  But a front page story in the WSJ detailing how traders at Merrill, Citi, Deutsche and UBS attacked Morgan Stanley in late September by purchasing credit default swaps in what may have been a coordinated attempt, points out how willing Wall Streeters are to punish each other.  Somehow, they don't seem to understand that forcing Morgan Stanley into collapse may pose irreparable damage for their own business.  Or perhaps they understand the business is doomed and only the government can save them now?  They want the TARP back and the governments seems only too willing to comply.        

Obama Transition Team Considering Bankruptcy "Prepack" for Automakers

President-Elect Barack Obama's transition team is considering a prepackaged bankruptcy for the automakers as a potential solution.  This may be the answer for the beleaguered automakers.  Although many have been calling for a bankruptcy solution for GM, F, and Chrysler, the implications of a potential bankruptcy have been weighing on the markets like a ton of steel.  A Chapter 11 filing during ordinary markets wouldn't necessarily be catastrophic; the airlines seem to do it every couple of years.  The biggest concern about a bankruptcy filing by the automakers right smack in the middle of the credit crisis has been the lack of availability of debtor-in-possession financing.  DIP financing is crucial during a Chapter 11 in that it allows companies to continue to fund operations while working through complicated negotiations with creditors.  GE Capital, the largest provider of DIP financing, recently announced it was exiting the business.  Without access to this type of financing, the probability of a Chapter 11 bankruptcy leading to a liquidation has increased dramatically for any company seeking protection from creditors.  The thought of all three automakers needing a huge amount of this type of financing during a period of such constrained credit is just too much for the markets to bear. 

A prepackaged bankruptcy with the government providing the interim financing is perhaps the ideal solution.  The automakers could restructure all of their burdensome obligations, allowing them to better compete with the foreign automakers.  If a deal was reached with creditors prior to a bankruptcy filing, with the government's financial support, consumers would not shy away from purchasing vehicles from the companies because a clear exit strategy would be in place.    

Top Ten Surefire Signals of a Market Bottom

Not a minute goes by on CNBC when commentators aren't furiously debating whether a "bottom has been set."  First there was definitely a bottom in March.  Definitely.  Followed by another bottom in July.  I've never seen a better bottom.  Then we had October 10th.  Seriously, has anyone seen a bottom more definitive than October 10th?  The inverse upside down quadrangle band was reaffirmed at least 17 times!  That had to be it.  Unfortunately, equity investors are facing yet another potential bottom today.  Could this one be it?  To help those confused investors determine the actual bottom, I have put together a short list of events that must occur for a bottom to be put in place.  If you see these events occurring simultaneously, I strongly urge you to start buying stocks with both hands.

1. Prince Alwaleed stops thinking Citigroup is a great investment.  Believe it or not, the Saudi Prince is STILL buying. 
   
2. Debt investors throw in the towel on GMAC and ResCap, refuse to swap their debt for more debt and mark that garbage down to zero where it belongs.  GMAC still seeking bailout from Feds; still swapping debt.
3. Maria Bartiromo jumps out the window on live TV (but lives and returns to work the next day in a cast; I'm not that morbid.)  Ms. Bartiromo is still on my tube shrilly yelling at guests to explain to her WHAT the HELL is GOING ON because she's been telling people for ten years that stocks are a great investment and this is making her look like an idiot!
4. Vladmir Putin stops threatening the Russian market with violence if it doesn't cease collapsing.  Mr. Putin pledged to do "everything" to prevent a financial crisis.  He did not rule out invading the stock exchange.
5. Somali Pirates lower their ransom demands from $25 million to $1.50 when they realize that an oil tanker is virtually worthless in this economy.  Somalis still not following commodity futures market; still want $25 million. 
6. News reports stop including "The worst level in 27 years!" in every headline.
7. Microsoft uses its $30 billion cash hoard to buy Chrysler, Ford, GM, Citigroup, JP Morgan and Bank of America.  The Justice Department does not block the deals on anti-trust grounds.
8. Ben Bernanke and Hank Paulson cry like babies in unison on television at some sort of press conference that they called to attempt to instill confidence in the market.
9. Not a single airline files for bankruptcy during the downturn.
10. SEC Chairman Chris Cox comes out from whatever hole he's been hiding in ever since his short-sale ban was a flop, and tries to institute a ban on selling stocks.  Hank Paulson punches him in the face on live television at the aforementioned conference (see 8.) and Ben Bernanke has to hold Mr. Paulson back to keep him from doing any real damage.  All of them are still crying as they make a beeline for the hellicopter.  (This last one is more of a fantasy and less of a real indicator.) 

AutoMakers Plead For Government Funds as Economic News Worsens

The CEOs of GM, Ford and Chrylser are scheduled to testify for a second day on Capital Hill, this time in front of the House Financial Services Committee after hitting up the Senate for cash yesterday.  I don't have a particularly strong stomach so I only watched bits and pieces of the testimony as the remarkably contrite auto chiefs attempted to make a case for some sort of capital injection.  They repeatedly emphasized that a Chapter 11 filing would be catastrophic and would more than likely push them into Chapter 7 liquidation as consumers fled their brands due to fears that their warranties would not be honored.  Not surprisingly, the Senators bashed the CEOs and accused them of financial mismanagement.  It is hard to stomach, given that this administration that has presided over the grossest financial mismanagement in the history of the free world.  Aside from the billions upon billions that have been thrown at the banking system, let's not forget that AIG just received $150 billion in government money about a week ago.  Why, for the love of god, is okay to grant the giant money-sucking-CDS-selling-insurance-mismanager $150 billion in government funds to prevent systemic risk, but not okay to give the auto-companies a $25 billion injection?  What about Citigroup?  Citigroup, made the front page of the Financial Times today because it is liquidating it's ninth hedge fund due to catastrophic losses.  This is a fund, mind you, that the bank already injected capital into and will wind up costing Citi hundreds of millions of dollars.  The US government had no problem forking over $25 billion to Citigroup so it could bailout its failed hedge funds.  But somehow, because the unions are involved and blue collar workers face the prospects of losing what are viewed as very cushy benefits, it is not as palatable as handing money to an industry that paid out billions in bonuses for years on phantom profits that ultimately caused the collapse of the global economy.  I don't like the UAW either, but seriously, isn't anyone else disgusted by this hypocrisy? 

I definitely don't think our government should've bailed out any of these firms but the systemic risks were viewed as too high and even with government bailouts our economy is tanking, so clearly something had to be done.  The problem is that decisions now need to be made to determine who is big enough and poses enough of a systemic risk to need bailout funds.  Had you asked me a year or two ago if we should bailout the automakers, I would have emphatically said "no."  But I think that the unintended consequences of a Chapter 11 filing right now of the entire US auto industry would be far too catastrophic.  The economy is too fragile, and attempting to settle all of the outstanding debt of the automakers would send the credit markets into a further tailspin.  

Meanwhile, in headline economic news, CPI fell 1% last month mostly due to a plunge in energy prices (good), although food prices rose .3% (not good) and ex food and energy declined .1% (just okay.)  Housing starts plunged to an annual rate of 791,000, the lowest since records began in 1959.  Although economists and the media will focus on the devastating effects of deflation and start comparing the US to Japan in the 90's, I actually think it's positive that builders are slowing down the pace of construction.  Maybe at some point we can finally clear out all of the inventory that is sitting around.  As for paying less at the pump for gas, frankly, I'm a big supporter of that too.  

CMBS Hitting the Fan

Stock market investors who find themselves perplexed by the continued weakness in insurers and financials can look for clues in the commercial mortgage backed securities market.  In addition to the residential mortgage debacle, banks and insurers hold huge portfolios of commercial mortgage loans and securities, investments which are currently getting pounded due to increasing fears of impending defaults.  The Wall Street Journal has a great story detailing the rapid deterioration in CMBS.  According to the article, the market for debt used to finance hotels, offices and shopping malls tumbled Tuesday on fears of a wave of defaults in the $800 billion commercial real estate securities market.  Two big commercial mortgages that were packaged into securities in the past year are on the verge of defaulting.  Both of the large loans, a $209 million loan backed by two hotels and a $125 million loan backed by a mall, were "pro forma" loans.  For those unfamiliar with the jargon, "pro forma" is investment banking-speak for "numbers we invented."  You see, if the actual cash flows from the building were utilized, the loans wouldn't really make sense financially.  In order to get around this minor inconvenience, the goons at JP Morgan, who underwrote these specific loans, just assumed that operating income would go up, alot, in the future.  And really, why would they even care?  The loans were just shoveled into a CMBS and passed along to the boob investor who bought the securities because some idiot at the rating agency slapped it with a AAA rating.  Given that this level of underwriting scrutiny was the status quo for several years, can anyone possibly be surprised that spreads in AAA CMBS have widened to record levels?

The overall number of commercial mortgages packaged into securities that are 30 days or more past due rose to .64% in October from .39% at the end of last year, with most of the increase coming in October.  Although fairly low by historical standards, the delinquency rate was the highest in two years.  Clearly delinquencies are set to soar as borrowers are unable to refinance into new loans on terms similar to those they negotiated during the boom.  Furthermore, with the economy weakening significantly, operating income is more likely to decline as office vacancies increase, consumers stop visiting malls, and both business and pleasure travelers cut back on time spent at hotels.  The news in the commercial real estate market is likely to get much worse.  

 

YHOO and HP Goose the Market, Financials Slap It Back Down

Jerry Yang has announced he will step aside and allow Yahoo to seek a new CEO.  This is probably one of the best decisions Mr. Yang has made for the company in a very long time.  His decision to scorn Microsoft's $40 billion bid for Yahoo will go down in history as one of the worst made by a non-financial company CEO.  That statement is not in hindsight.  It was patently clear at the time to anyone with half a brain that the company should've accepted Microsoft's bid.  I don't attest to have more than half a brain but you can read my comments mocking the idiot analysts at the time who kept claiming how badly Microsoft (holder of multiple billions in cash) needed Yahoo ($18 stock at the time with declining prospects) and how Mr. Softy would certainly raise his bid to win his prize.  Microsoft may or may not be back now that Mr. Yang is stepping down, but it is unlikely to bid much of a premium in this market.

In the surprisingly good new department, Hewlett-Packard actually raised guidance for the fourth quarter.  I know, I can't believe it either.  But good news is rare these days, so the market will take what it can get.  

Futures were higher on the HP and Yahoo news, but the market is roughly flat in early morning trading as attention returns to battering the living stuffing out of financials.  Make no mistake, the financials deserve their battering.  Hank Paulson and Ben Bernanke are testifying on Capital Hill today with Sheila Bair in tow.  Mr. Paulson has noted that he does not intend to use any more of the TARP while in office, unless absolutely necessary (i.e. some bank or insurance company calling him at 3 am).  Since financials trade mostly on government intervention news, investors are hoping to figure out what the newly elected administration plans to do with the rest of the money and if some companies will actually make it until the new administration takes over in January without an injection of funds.  This explains why insurance stocks are getting pounded and why they are considering buying small savings and loans to access to more liquidity.          

Are Citi and Goldman Finally Facing the Music?

Citigroup's CEO Vikram Pandit held a town hall meeting intended to boost morale, and then announced that the bank will be eliminating more than 50,000 jobs or about 14% of its workforce.  I'm not sure how that town hall meeting was supposed to bring anyone back from the ledge, but at least the bank is getting realistic.  Citigroup announced that the company was planning to reduce expenses by 20%, targeting 2009 expenses of $50 to $52 billion.  The reports do not mention whether Citi plans to cuts the rest of its dividend.  But at some point it should sink in that paying a government-sponsored dividend in these times is flat-out moronic, not to mention politically unwise.

Meanwhile, in a masterful public relations move, top executives at Goldman Sachs have decided to forgo their 2008 bonuses.  Although Goldman has (so far) had a reasonably profitable year in what has been a disaster for other banking institutions, senior management has figured out that it is far less painful to give up a bonus than try to explain their compensation to Henry Waxman.  It is hard to make a case that your executives "deserve" millions in pay when the investment bank is surely being kept afloat by the Fed through its numerous new toxic-asset financing facilities.  Furthermore, partners at Goldman make $600,000 in salary and have all been showered with millions in compensation for the past several years.  Nobody at the senior ranks of Goldman is going to starve without a bonus this year.  Employees of Goldman Sachs are no doubt nervous about this announcement as it has implications for their own end-of-year compensation.

It is widely known that securities industry professionals are an extremely well-compensated lot.  The industry is clearly shrinking and many who were accustomed to getting paid hundreds of thousands and even millions a year are now facing the prospects of living off of their salaries or being unemployed for a very very long period of time.  The interesting follow-up question remains:  How will the contraction of the securities industry affect other sectors of the economy that thrived off of the Wall Street boom of the last few years?  It is widely known that investment banks were leveraged 35-to-1 during the boom.  But how leveraged were the bank's employees?  While it is certainly probable that some percentage of securities industries professionals lived within or even beneath their means, it seems more likely that a large percentage expected to collect huge bonuses every year to maintain their extravagant lifestyles.  How many of those shiny new Manhattan luxury condos are going to come on the market within the next two months?  What will this do to other luxury goods retailers?  Villa rentals in the Caribbean?  Prices on contemporary art?  Ferrari dealerships?  Secondary home prices in the Hamptons and Nantucket?  The list goes on and on.  But I suspect that if you're in the market for a slightly used Rolex, you're probably going to get a great deal. 

Freddie Mac Posts $25 Billion Loss, Requests $14 Billion From Treasury

Freddie Mac posted a $25 billion third-quarter loss.  The losses were tied to the writedown of $14.3 billion in deferred tax assets, $9.1 billion in security impairments on its available-for-sale securities and $6 billion in credit-related expenses arising from the "dramatic deterioration in market conditions."  These losses officially take Freddie's book value into the negative by $13.8 billion, requiring a capital infusion from the US Treasury.  As a refresher for any readers who have successfully blocked all the horribly depressing financial news from their memories, both Fannie and Freddie were placed into conservatorship of the Federal Housing Finance Agency of September 6th.  The Treasury has pledged to inject capital in the form of preferred shares into the mortgage lenders when the value of their assets declines below the value of their liabilities up to a maximum amount of $100 billion for each company.  Fannie's $29 billion loss reported on Monday did not require a capital infusion yet, but most analysts expect that the company will need one after the fourth quarter unless the mortgage market improves dramatically.

Why is GE Still Paying a Dividend?

GE reaffirmed plans to maintain its 31-cents-per-share through the end of 2009.  The company went on to say that "GE expects industrial cash flow to be greater than the amount needed to fund the dividend in 2009."  Here's a suggestion:  Maybe use all of that industrial cash flow to pay off some of your debt?  Because aren't you paying the FDIC a fee to guarantee $139 billion of GE Capital's debt?  Wouldn't it be prudent to instead reduce some of the $65 billion or so in commercial paper that you can't hock to any investors except for the Fed?  Maybe save some of that cash flow to help pay for the 10% dividend you handed to Warren Buffett for his $3 billion "confidence" investment?  Perhaps preserve some capital to increase loss reserves on GE Capital's loan portfolio that is certain to get the stuffing beaten out of it in a nasty recession?  I don't know.  Call me crazy, but GE is not in any position to be paying a dividend right now.  I'll give Mr. Immelt small bonus points for halting the stock buyback program earlier this year, but continuing with a dividend payment is ridiculous for a finance firm that has meaningful risk tied to the mortgage market and depends on the bond market for financing.

I have written several posts about the lack of transparency of GE's balance sheet and the inherent risks lying in its GE Capital finance unit.  Given the drubbing the stock has taken, investors are waking up to the reality that GE really is a finance firm with an attached industrial conglomerate.  I know that GE doesn't want to anger its loyal shareholders, but I'm fairly certain that any shareholder with half a brain will understand.