Friday, August 29, 2008

GM Wants $50 Billion From Uncle Sam

GM has stepped up its marketing efforts to gain favor for the beleaguered US auto industry from Uncle Sam.  I suppose the automakers believe that if the entire financial sector can get loans from the Fed to stay afloat, why shouldn't US car companies?  According to the New York Times, GM Vice Chairman Robert Lutz claims that "The American auto industry is deserving of government loan guarantees."  According to Mr. Lutz, US automakers need to build more fuel-efficient cars.  They can only do this if Congress acts by the end of September to grant them $50 billion in loans.  This is a matter of national emergency now because the US auto industry was too busy helping consumers purchase non-fuel-efficient SUVs and trucks by offering attractive financing for the past several years.  They didn't have time to concentrate on fuel-efficiency because they were too busy making money on large vehicles sales.
In curiously-related front page news, Delphi, the auto-parts maker, looks less likely to emerge from Chapter 11 as a standalone company.  If a liquidation occurs, GM will take over some of the plants.  According to the Wall Street Journal, the auto-parts maker is facing several financial hurdles before the end of the year.  Delphi's financing expires at year end and its current lenders are unlikely to renew.  GM will need to either inject cash into the pension plan or assume some of it.  A liquidation of Delphi, which employs 159,000 and had $22 billion in revenue last year, would be extremely expensive for GM, who would need to decide whether to continue running some of the plants to keep parts flowing to GM's assembly lines.  So, you see, a $50 billion loan could come in very handy right about now.  
With sales of cars and light trucks down 20% so far this year, the US auto industry is running out of ideas to stay afloat.  Government loans certainly seem like an easy way out.  Increased fuel-efficiency in cars on the road is currently a politically savvy priority.  Asking for a government loan under the guise of environmentalism may be viewed as a brilliant PR move.  Skeptics like myself find it hilariously ironic.  

Thursday, August 28, 2008

Second Quarter GDP Surprisingly Strong

US GDP was revised higher from an initial estimate of 2.7% to a 3.3% annual rate in the second quarter.  Amazing the things we can accomplish when the government sends almost everyone in America a check for $600.  In fairness, the strong GDP number was also aided by the weak dollar that made US exports cheap relative to our foreign competitors' goods.  As a consequence, even a curmudgeon like myself has to admit that this GDP report is pretty good.  The report indicates that the economy is so healthy that I have to wonder if the folks over at the Fed are even the tiniest bit concerned about fanning the flames of inflation with a 2% fed funds target.  Of course, our friends at the Fed are too terrified about the next shoe to drop in the financial sector to ever pay attention to economic reports anymore.  I would even surmise that these are the Fed's current priorities:
  1. Check the open market operation desk to ensure that every dealer met yesterday's margin calls
  2. See if any new bank or dealer showed up at the discount window for large amounts of cash
  3. Call Fannie and Freddie and see if they need any money
  4. Call FDIC and see if they need any money
  5. Prepare the next speech and find a new way to say that the coming crash in financial markets should take the edge off of inflation, without sending everyone into a panic     

Wednesday, August 27, 2008

Increased Financing Costs A Certainty For Banks, Leading to More Uncertainty

The Wall Street Journal has a front page story on the amount of floating-rate notes that banks will have to rollover within the next few years.  According to a JP Morgan analyst, financial institutions will have to pay off $787 billion in notes before the end of 2009.  A mere year ago, floating-rate notes were priced at .02 percentage points over Libor.  Investors are currently demanding more than 2.0% over Libor.  The spread has widened so much primarily because SIV's used to be large buyers of these floating-rate notes.  Remember SIV's?  They went extinct with the Dodo bird.  For those who don't recall, SIV's were off-balance-sheet vehicles created by the banks to off-load assets to juice returns.  The sad truth is that banks are having trouble finding buyers for their floating-rate debt because they can no longer sell it to themselves. 

Where can the banks turn to find cheap financing?  Why the Fed, of course, and the ECB if you happen to be a European Bank.  As it turns out, the ECB has been far too friendly to the banks that have sought funds.  It has been no secret that the ECB has been concerned about the type of collateral it was allowing banks to pledge against its loans.  I wrote about this in a story on May 16, 2008 where I invented a mock scenario of how bankers are likely to game the Fed and the ECB.  Apparently, there is evidence that the ECB has been allowing the banks to price the collateral at higher prices than where it is trading in the market.  As a consequence, banks can carry these assets at artificially high prices while financing them at artificially low rates.  Although it is quite possible that credit market conditions will improve and all of those billions in loans will be repaid to the Fed and the ECB within the next few years, another extremely likely scenario resembles the Danish Central Bank's takeover of Roskilde Bank.  The Danish Central Bank was forced to inject funds into Roskilde when it couldn't find a private buyer and didn't want to face the prospect of a financial meltdown in the banking sector due to a bankruptcy.  According to Danish Central Bank Governor Nils Bernstein, Roskilde's failure was "unique" and linked to a "very large exposure to the real-estate market."  Unique?  Large exposure to the real estate market?  I wonder if I can think of any US banks that are borrowing from the Fed that have a very large exposure to the real-estate market.  I wonder. 

Tuesday, August 26, 2008

Still Looking for That Bottom in Housing

A bevy of housing data has been released in the past 24 hours.  Economists and analysts are busy analyzing the data and attempting to search for that ever-elusive bottom in the housing market that is sure to save us all.  On the plus-side, new-home sales in July rose 2.4% to a 515,000 annual pace.  However, June was revised sharply lower from a previous estimate of 530,000 to 503,000.  Economists were expecting a decline from 530,000 to 525,000.  If you read between lines, you can conclude that the new home sales numbers are much worse than anticipated.  Furthermore, the median price fell 6.3% to $230,700 from the prior year.  The only glimmer of hope resides in the inventory numbers, which showed a decline in the number of unsold homes to a 416,000 pace, a 10.1 months' worth supply.  Builders have obviously cut back on new projects and are offering incentives to unload their bloated inventories.  While this is positive news, it doesn't tell the whole housing story.  Inventory numbers released yesterday with existing home sales weren't as cheery.  Sales of previously owned homes rose 3.1% to an annual rate of 5 million from 4.85 million in June.  The median dropped 7.1% from July and inventories rose to a record 11.2 months' supply.  Existing home sales account for 85% of home sales, which I believe gives the bigger overall picture of the state of the housing market.  The jump in inventory was driven by an increase in the supply of condos.  Because what we really need in this country is a few more condos, especially in Florida.
The Case-Shiller home price indices data for June was also out this morning showing a decline of 15.9% from the previous year.  The composite 10 index was off 17% year-over-year.  Economists were expecting these numbers to be worse, so that is positive news.  However, note that the trend is still lower.  If you factor in how much credit conditions have tightened since June, it is hard to believe that we've finally found the bottom as some optimists believe.  But hope springs eternal, particularly since the fate of the U.S. banking system hinges on a recovery in housing, which is far more palatable than more government bailouts.           

Bank Regulators Increase Memorandums of Understanding

The Fed and the Office of the Comptroller of the Currency have issued more memorandums of understanding so far this year than in all of 2007.  These agreements, meant to remain secret to avoid panic by depositors, can force banks to raise capital, cut back on risky loans and suspend dividend payments.  The FDIC will be updating its list of "problem" institutions today.  As of March 31, the FDIC had 90 banks on the list and I suspect the list will only grow larger.  Five banks have failed since July 11.
According to the Wall Street Journal article, BankUnited Financial, a Coral Gables, Florida-based bank, disclosed on Monday that its $14 billion banking unit recently entered into an agreement with the Office of Thrift Supervision over concerns over capital levels.  The Bank was apparently stuck in some sort of 2005 time warp as it was ordered by the Office of Thrift Supervision to end its option adjustable-mortgage and alternative mortgage business.  How a Florida-based bank that still thinks option-arms are a good idea remains in business today is a mystery.  But at least our trusty regulators put a stop to it.  Better late than never, I suppose.
Investors have expressed frustration with inconsistency of public disclosures of banks of regulatory scrutiny.  "It's frustrating as an investor in bank stocks", Gerard Cassidy, an RBC Capital analyst noted.  He claimed that "It would be very helpful in an investor's analysis if they knew that an agreement was already signed."  Naturally, it would make an analyst's job easier, for it would save him many hours of actually looking at a balance sheet and attempting to figure out whether a bank is going to survive based on its financials.  But if you need a regulator to tell you that a bank is in trouble, maybe you shouldn't be an investor in bank stocks.  

Monday, August 25, 2008

Korean Regulators Put Kibosh on KDB/Lehman Takeover Rumors

South Korea's top financial regulator indicated that it was not pleased at the prospect of a Lehman takeover by Korea Development Bank.  The regulator warned that KDB should take a "cautious" approach to buying an overseas bank and that such a deal should be led by private lenders.  Piling on $630 billion in Lehman's assets onto KDB's $120 billion balance sheet can only be viewed as cautious by those who feel Fannie Mae doesn't have enough leverage.  Investors who actually drove up the price of Lehman on Friday purely on the basis of this ridiculous idea may have been the same ones who bought into Richard Bove's widely circulated analyst note which surmised that Lehman was ripe for a hostile takeover.  The note received a ridiculous amount of press, presumably because it was a very slow news day.  Nevertheless, it made me consider hiring Mr. Bove's publicist because I can't understand how something so inconsequential could get so much attention from the financial press.
The basic gist of the note is that Lehman's management believes its assets are more valuable than the market price.  The company has made numerous attempts to sell a variety of assets but refuses to accept the bids it is receiving from potential investors.  Based on the fact that the market capitalization of the entire company is equal to his valuation of the Neuberger Berman subsidiary, Mr. Bove concludes that the company is grossly undervalued and is ripe for a hostile takeover.  I tend to draw an alternative conclusion: that management at Lehman is completely delusional and is not willing to accept that its valuations are overstated.  Furthermore, I look at the investing climate and wonder who is in a position to perform a hostile takeover of an investment bank with over $600 billion in assets?  I would immediately rule out the remaining investment banks due to too much overlap in businesses.  The large money center banks have so many of their own problem assets that they would not want to digest such a huge acquisition.  Wells Fargo, one of the few healthy financial institutions large enough to actually do the deal, is featured in a front page Financial Times story claiming it has no interest in acquiring a struggling rival.  Private equity is out because of regulatory issues, not to mention financing issues.  So who's left?  Overseas banks?  Maybe, but unlikely.  It seems we can count the Korean's out. 

Friday, August 22, 2008

Yet Another Treasury Official Blabbers to the Press About Fannie and Freddie

Speculation continues to circulate about the future of Fannie and Freddie.  The general consensus seems to be that the government will inject equity into the GSE's in the form of some type of preferred shares.  According to a variety of "informed" sources the new equity would rank senior to the common, thus wiping out the existing equity holders and diluting the preferred shareholders.  If you read the Barron's article over the weekend, or the report in the Financial Times, you would be led to believe that "inside sources" confirmed this outcome.  However, Reuters has yet another "source familiar with Treasury thinking" who claims that "any effort by the Treasury Department to backstop Fannie Mae and Freddie Mac would seek to maintain the companies as shareholder-owned enterprises.  So, what's it gonna be?  I was gearing up for a big announcement from the Treasury over the weekend about its plans to deal with the GSE's.  But this new report makes me wonder if the Fed is just going to sit back and wait it out.  Concerns have been circulating about the $225 billion in debt that Fannie and Freddie has to roll over before September 30th.  Frankly, the Fed has already loaned Wall Street over $300 billion to help finance their mortgage and agency inventories, so what's another $225 billion?  The Fed owns over $479 billion in treasuries which it can sell and replace with agency paper and earn a much nicer spread.  Doing this would be completely insane, but frankly, it's no more crazy than the idea of fully nationalizing Fannie and Freddie.  What the Treasury actually decides to do is anyone's guess at this point.  One thing is for certain, if nothing happens over the weekend, investors should prepare themselves for yet another bumpy ride.   

Can KDB Buy Lehman?

Reports about Korea Development Bank taking over Lehman Brothers has caused optimism to return to the financial sector.  Reuters initially reported that the bank was "open" to an acquisition.  Both Lehman and KDB declined to comment on the story so investors assumed there was a nugget of truth to the rumors.  What I have yet to see so far is any discussion on whether KDB actually can afford to buy Lehman Brothers.  I took a quick look at KDB's balance sheet and noted that at December 2007, KDB only had 146 trillion Korean won in assets and 21 trillion Korean won in shareholder's equity.  With the Korean won trading at 1,062 to the dollar, this translates into roughly $146 billion in assets and $21 billion in shareholder's equity.  And it plans to pile Lehman's $639 billion in assets and $613 billion in liabilities onto its balance sheet?  And then go private?  It seems incredibly unlikely to me.
Analyst Richard Bove made a very bold call yesterday claiming that Lehman was ripe for a hostile takeover.  Sure it is.  Given Lehman's recent frantic attempts to strike a deal with anything that moves to sell whatever it can get a bid for, I am hard pressed to believe that Lehman is cheap.  If anything, given how spreads on MBS and CMBS have continued to widen back to levels not seen since March, Lehman's assets continue to deteriorate which means more writedowns, more losses, and a need for more capital.  The only financial institution in a position to do a hostile takeover of Lehman is the Fed, and they have their hands tied with Fannie and Freddie...      

Thursday, August 21, 2008

FDIC's Sheila Blair Vows to Keep Delinquent Borrowers in Their Homes

Yesterday, the FDIC unveiled a plan to keep thousands of currently delinquent IndyMac borrowers from losing their homes to foreclosure.  IndyMac, a formerly top ten mortgage lender that specialized in Alt-A loans during the boom, was seized by the FDIC on July 11th in one of the largest bank failures in US history.  The plan involves modifying thousands of loans through a combination of interest-rate reductions, longer repayment periods and principal forbearance.  The modifications will result in the reduction of homeowners' debt to no more than 38% of income.  Borrowers will need to provide documents verifying their incomes to have their loans modified.  Borrowers will be eligible for the program if they have a first mortgage serviced by IndyMac and are "seriously delinquent" or in default.  
According to Ms. Blair "Our goal is to get the greatest recovery possible on loans in default or in danger of default, while helping troubled borrowers remain in their homes."  I am thoroughly in agreement with Ms. Blair about getting the greatest recovery possible on the loans to keep the costs of this messy bailout at a minimum.  However, I don't think that helping delinquent Alt-A borrowers keep their homes should be a priority for the US taxpayer.  In most cases, Alt-A loans were granted to borrowers with good credit scores who stated their own incomes without providing documentation.  What happens if the loan modification documents are returned by the delinquent borrower to the FDIC with proof of income that shows that the borrower clearly overstated his income in order to obtain a loan to buy a house that he otherwise couldn't afford?  Is the FDIC still going to modify that mortgage, grant that person forbearance, so that he gets to keep his house?  What about the guy who lives next door to the delinquent borrower, who pays his mortgage every month on time and never lied about his income to purchase his house?  If the FDIC is so concerned about keeping liars in their houses, they should foreclose on the property, sell it to an investor, and allow the delinquent borrower first dibs on renting the house from the investor.

KDB, Citic Walk Away From Lehman Investment

According to the Financial Times, Korea Development Bank and Citic Securities of China met with Lehman Brothers in early August to discuss a sizable equity investment in the US investment bank.  The talks failed.  The deal Lehman was negotiating with the South Koreans would have called for KDB to take a 50% stake in the beleaguered investment bank at a price of around 50% above book value.  Apparently, the two sides were close to a deal but last-minute disagreements caused negotiations to fall apart.  I can only speculate on what those disagreements may have been.  Perhaps the misunderstanding hinged on a translation problem.  Maybe KDB thought they were getting an investment at 50% of book value.  After all, Lehman's current market capitalization is less than half of book.  Once Lehman corrected the Koreans by stating that they expected an investment of 50% ABOVE book value, the Koreans balked.  Perhaps KDB then tipped off the Chinese bankers on the investment bank's  unreasonable expectations, as Citic declined to invest before getting very far with negotiations.  
Now we sit and wait for Lehman's next move.  Can it negotiate a sale of its mortgage assets at a reasonable price?  Maybe a sale of the asset management unit will be announced soon?  Lehman seems to want to strike some sort of a deal before the earnings announcement.  That can only mean one thing:  The announcement is bound to be ugly. 

Wednesday, August 20, 2008

Another Day, Another Plunge in Fannie and Freddie Shares

Shares of Fannie Mae and Freddie Mac are down on the day again, as investors continue to race for the exits.  Rampant speculation continues about the future of the mortgage giants, with many calling for a nationalization of the two firms.  Remarkably, the Treasury Department has been mum about the matter, claiming that it has no immediate plans to intervene in the two firms activities.  I am not terribly surprised by the plunge in Fannie and Freddie's stocks (or their preferred and sub debt.)  However, I find the widening of spreads on Fannie and Freddie's senior debt to be a real head scratcher.  Spreads on Fannie and Freddie's senior debt are wider than they were before Hank Paulson announced that the government would inject unlimited funds into the GSE's.  If the government is supporting  these two firms financially, then owning Fannie and Freddie's debt should be the same as owning US Treasuries.  If anything, Treasuries should get pummeled because the potential debt burden on the US government has increased by a couple of trillion dollars.  Yet somehow, Treasuries are still being viewed as a "safe haven" while Fannie and Freddie's debt is looking more like toxic waste.  Those with good insight about this situation are welcome to comment.  For interesting commentary on the precarious situation the Treasury faces with the GSE's, Naked Capitalism has a great summary that is worth reading.

Tuesday, August 19, 2008

A Crazy Plan for Hank Paulson on Saving Fannie, Freddie, and Lehman

When Hank Paulson took his post as US Treasury Secretary, he probably thought it would be a nice relaxing break from the high-stress job of running Goldman Sachs.  After all, what does a Treasury Secretary do, other than shake hands with figureheads and make emphatic statements claiming to support his administration's "strong dollar policy?"  Mr. Paulson, however, has found himself in the difficult position of attempting to bailout most of the US financial sector while avoiding the use of taxpayer funds.  The US market narrowly avoided a complete meltdown in March when Paulson forced JP Morgan to buy Bear Stearns.  It would've been the perfect plan were it not for the $29 billion in dicey mortgages that the Fed has guaranteed for JP Morgan.  No use of taxpayer funds, yet.  Expanding the type of collateral that the Fed will take in its loans to Wall Street to include triple AAA rated MBS and ABS was also inspired genius, assuming that none of these institutions fail and leaves the Fed holding undesirable collateral in a panicky market.  Opening the discount window to investment banks was a shrewd move to shore up confidence and keep Lehman from facing Bear's fate in March.  Investment banks have yet to tap the discount window.  So far, so good.  When Fannie and Freddie's stocks began to plummet on fears that they were insolvent, Paulson crammed through a landmark housing bill that had stalled in congress in order to make the implied government guarantee explicit.  Although I am not a mind reader, I believe that Paulson was hoping that the explicit guarantee would boost confidence so much that the government would never have to take an equity stake in the faltering mortgage entities.  The market, however has called his bluff.  Fannie and Freddie's shares have been reeling, dragging down the recently rebounded financial sector on a belief that the government will have to make an equity infusion that will wipe out the common and potentially the preferred shareholders.
Since desperate times call for desperate measures, I have a crazy plan for Mr. Paulson on how to save Fannie, Freddie and Lehman while making a few bucks in the stock market.  First, call Lehman Brothers and tell them that the government plans to buy one billion shares of Fannie and Freddie tomorrow, giving Lehman one trading day to front-run the order.  Then, Mr. Paulson can give the order to Lehman to buy one billion shares the following day at the market.  Since this is around ten times the average daily volume, both of the stocks should spike significantly.  A short squeeze will follow as the small-time shorts get squeezed out.  Mr. Paulson can then call Chris Cook at the SEC and tell him to put out an emergency short-sale ban.  The SEC must outlaw ALL shorting, not just the naked variety.  The stocks will surge higher as shorts are forced to cover.  Once both share prices have quadrupled, Fannie and Freddie can raise more capital from a few strategic foreign investors.  After all, this has got to look like a great investment compared to the Chinese or Indian stock markets of late.  Although the government's share will be diluted by the new capital raising, it should be more than offset by the appreciation in the stock.  Lehman, having front-run the buy side, can also front-run the equity issuance and post a gain that may help offset the $4 billion or so in losses that it is more than likely to have this quarter.
If all of this sounds crazy, then you haven't been keeping up with current events.  It only seems slightly more crazy than the reality confronting the market.  Fannie and Freddie on the verge of a direct equity infusion from the government?  Insanity!  Lehman's stock getting annihilated again because all of those "rumors" about untenable losses turned out to be true?  Shocking!  Is everyone at Lehman "comfortable" with those marks now that the investment bank is yet again desperately searching for new ways to raise capital?  Erin Callan can thank Dick Fuld for giving her the boot, as it was a better move for her career than Mr. Fuld's.  Mr. Fuld has nowhere else to point the finger.
Only time will tell how the turmoil in the financial markets will finally be resolved.  You can bet on more surprises along the way.  The only thing that seems certain is that the financial universe will continue to shrink as players get weeded out during the downturn.  Pundits attempting to call the bottom will eventually grow weary.  Only when completely crazy ideas begin to sound reasonable will a bottom begin to form.  When I get a call from Mr. Paulson asking for the outline of my plan, I'll let you know it's safe to buy financials again. 

PPI Surges 1.2%, Housing Starts Plummet 11%

US PPI was up 1.2% in July, with the core up 0.7%.  If these numbers look unexpectedly high, you are not experiencing double vision, July PPI was twice what economists were expecting.  Some will try to blame it all on food and energy, but a 0.7% increase in the core is a very ugly number.  If you'd like to blame it on someone, you can blame it on the Fed, who has made a very difficult choice in siding with the banking system over the ordinary consumer in its recent monetary policy decisions.  Runaway inflation is surely a result of a 2.0% fed funds target in the face of rising inflationary pressure.
Meanwhile, in housing-related news, housing starts decreased 11% to an annual rate of 965,000, the lowest since March 1991.  With housing inventories at elevated levels it is not a surprise that builders are not inspired to break ground on new projects.  Optimistic economists believe that the deflationary effects of the weak housing market should help to lower pressures on overall prices.  But the average American faced with rising prices and falling home equity can't afford to be so optimistic.

Monday, August 18, 2008

Bernanke: Where to Draw the Line?

Bloomberg has an interesting story today about the difficulties that Federal Reserve Chairman Ben Bernanke is facing in defining which institutions it's safe to let fail.  The article claims that the central bank has turned its balance sheet into "a parking lot for Wall Street's hard-to-finance bonds" and provides some startling evidence of that fact.  The Bloomberg article uses a source from Wrightson ICAP to support the claim that 94% of the Fed's $24 billion in outstanding repurchase agreements with Wall Street on August 10, 2005 were in U.S. Treasuries and that on August 10, 2008 only 14% were in treasuries with the rest in mortgage and agency bonds.  Those nerdy enough to care can go to the Federal Reserve's Statistical Release of Factors Affecting Reserve Balances which provides data for the week ended August 13, 2008.  The Bloomberg article neglects to mention that total outstanding loans to Wall Street have now reached $315 billion  ($118 billion in repurchase agreements, $150 billion in term auction credit, $17 billion in discount window borrowings and $29 billion in the Bear Stearns collateral that the Fed is holding because it was too toxic for JP Morgan.)  The Fed is currently using one third of its balance sheet in an effort to help Wall Street dealers finance their inventories at extremely attractive rates, thus boosting their profits and in certain cases keeping them solvent.  If banks were not allowed to go into the Fed with this type of collateral, they would need to find alternative and more expensive sources of financing.
With the Fed's new role as a temporary consulting regulator of Fannie Mae and Freddie Mac, in addition to its new regulatory powers over investment banks, the Fed can now make recommendations on capital and liquidity positions of the largest financial institutions.  The Fed also picked up new supervisory power over nonbank consumer-finance subsidiaries of bank holding companies such as CitiFinancial, a unit of Citigroup.  One has to wonder how much supervisory power can Bernanke handle?  Does he run the risk of supervising so many institutions that he ultimately becomes ineffective in managing any of them?  More importantly, how many bailouts can the US economy finance before our lenders become weary?  With the recent rally in the dollar, it appears as if the full faith and credit of the US government still means something.  But where does Mr. Bernanke ultimately draw the line?  How will he know which financial institution's failure will not cause cascading ripples through the financial system that would do irreparable harm to the US economy?  Perhaps the best way to solve this problem is a simple game of eeny, meeny, miny, moe.   
With all of his supervisory and "recommending" powers, I am still awaiting Mr. Bernanke's phone call.  I'm fairly certain he's going to tell me to deposit more money in my Citibank checking account.  I'll probably tell him I think I have enough to cover the phone bill.  He'll more than likely respond with "Of course you have enough money to cover the phone bill.  I'm not worried about you.  Citibank needs more deposits!"    

Friday, August 15, 2008

Wachovia Joins the Party and Settles With Regulators

Wachovia has agreed to buy back $9 billion in auction-rate debt, in a settlement with regulators.  In addition, Wachovia will pay a $50 million fine and make no-interest loans available for investors who need immediate liquidity.  Just in case you wanted access to your CASH instruments, Wachovia will gladly give you a no-interest loan against them.  As is customary, the bank is settling without admitting or denying guilt.  The bank is paying a $50 million fine and taking another $275 million charge against earnings to prove how not guilty it is!  In any event, Wachovia can get back to business, figuring out how to get rid of the $120 billion option arm albatross still wrapped around its balance sheet. 

Hedge Funds Struggle to Maintain Prestigious Image Amid a Barrage of Embarrassing Headlines

The reputation of hedge funds as a safe harbor for assets during market downturns has suffered numerous blows in the past year.  Through July, hedge funds were down 3.5% this year, according to data tracker Hedge Fund Research.  Investors may begin to ask themselves if the meager outperformance of the stock market is worth the risk of investing in a typically highly leveraged investment vehicle.  Remember Peloton Partners spectacular blow-out earlier in the year?  What about the seizure of Carlyle Capital by its lenders in March?  The number of internal hedge fund implosions and bailouts at investment banks in the past year (Bear Stearns, Citi, UBS etc.) have made it hard to believe that investment banks are still offered capital to manage.  The current CEO of Citi, Vikram Pandit, became a contender for the top post because Citi paid $800 million for his hedge fund Old Lane Capital despite unspectacular returns.  Since then, the fund has been shuttered due to disappointing performance and Citi has taken yet another writedown related to the restructuring.   
If you open the Wall Street Journal's Money and Investing section today, two highly embarrassing stories related to hedge funds may catch your eye.  First, a piece about how WexTrust Capital bilked a group of Orthodox Jews out of at least $100 million through an alleged ponzi scheme, followed by a story about an ex-UBS trader's hedge fund that has posted losses of 85% since the inception.  There is nothing funny about siphoning money from religious investors, many of whom based their investment decision on an uninformed Rabbi's personal recommendation.  The ex-UBS trader story, on the other hand, is kind of funny, although obviously not for any of the investors who have lost 85% of their money.  First of all, the founder of SRM Global, Jonathan Wood, managed to negotiate a five year lockup out of his investors when the fund was founded in September 2006.  Then he proceeded to invest in nearly every high profile flameout of the past year.  He was a big shareholder in Northern Rock, the U.K. bank that was bailed out by the Government.  Mr. Wood has since accused the U.K. government of using an unreasonable valuation process when it bailed out the bank, and that shareholders were shortchanged.  He also criticized Bank of America's bid for Countrywide as being too low.  The fund owned 8% of Countrywide as of early April.  Mr. Wood seems to have trouble accepting the ramifications of investing in insolvent financial institutions.  One can argue in Mr. Woods' defense that he merely picked the wrong sector to invest in.  However, the fund also owned Cheniere Energy, whose shares are down 86% for the year.  The energy sector has outperformed the overall market this year.  Yet, somehow, Mr. Wood managed to find the one energy stock that has posted a performance equivalent to a bank with subprime exposure.
Only one positive hedge fund headline has hit the papers this week, and it was related to an eye-popping compensation package.  Adam Levinson, the chief investment officer of the $8.8 billion global macro hedge fund was awarded a $300 million share grant by his bosses at Fortress Investment Group.  The fund has a solid performance history, although it is down 2% for the year.  Mr. Levinson reduced his profit-sharing interests in certain Fortress funds in return for the 31- million-share grant.  Mr. Levinson's trade of a huge chunk of equity in return for a reduced profit-sharing arrangement on a fund that is down on the year (i.e. profit = $0) is quite savvy.  Now that is great trade, for Mr. Levinson of course, not necessarily for Fortress' shareholders.  But if he routinely makes trading decisions such as this for his hedge fund investors then he is certainly worth the money.
Without a doubt, the large reputable hedge funds who have generated outsized returns to their investors for many years will continue to thrive.  In particular, the funds that saw the housing bubble from a mile away and managed to architect the right trades to profit from it will have no trouble raising capital.  But the days of raising $1 billion in a month just because you worked at a high profile investment bank are probably over.  Getting leverage of 100-to-1 from your prime broker will more than likely not be an option, making it harder to generate high enough returns to justify your fees.  Hopefully, the days of raising hundreds of millions of dollars on a Rabbi's recommendation are over too.  This is unfortunate for me alone, because I had a great investment strategy I was just about to pitch to my Rabbi this afternoon...

Thursday, August 14, 2008

CPI and Foreclosure Filings Higher

CPI rose 0.8 percent in July, following a 1.1 percent jump in June.  Core CPI (ex-food and energy) was up 0.3 percent.  The headline year-over-year CPI was 5.6 percent, a particularly difficult number for the market and economists to swallow.  However, with commodity prices declining significantly in the past month, the consensus among economists is that this is the peak in CPI.  Unless, of course, commodity prices head back up...
Meanwhile in deflationary news, US foreclosure filings were up 55% from the previous year.  Total foreclosure filings rose 8 percent from the previous month to 272,171 while bank seizures rose 184 percent to 77,295.  Through July 775,244 properties were owned by banks, compared with 445,000 for all of 2007.  Nevada had the highest foreclosure rate, followed by California and Florida.  Stockton, California no longer topped the list of the metropolitan areas with the highest foreclosure rates.  That honor now goes to Cape Coral Fort Myers, Florida.  Merced, Stockton, Modesto and Las Vegas round out the top five.  With prices of all goods heading higher, at least you can still buy a house for a song in a few key parts of the country.  

Wednesday, August 13, 2008

Analysts Continue Quarterly Brokerage Earnings Slashfest Ritual

Guy Moszkowski of Merrill Lynch downgraded Goldman and Lehman to "underperform" noting that "conditions have deteriorated significantly from July."  Meanwhile, Deutsche Bank analyst Mike Mayo cut his price target and estimates for Lehman Brothers.  He now expects Lehman to post a third-quarter loss of $2.68 a share, revised from a profit of 33 cents a share.  Why do I feel like I am experiencing deja vu?  Oh, that's right, because we go through this every single quarter.  How and why Mr. Mayo decided that today was the day that Lehman was going to go from a profit to a steep loss is only slightly mysterious.  After all, the market has been riddled with rumors of Lehman looking for buyers for its assets ("You need an asset management unit? Level 2?  Level 3?  We've got it all to go.  Just give us a bid.") for months.  If the company was cruising along making money, it wouldn't need more capital in addition to all the capital it has already raised.  Let's be honest, did conditions really deteriorate that much or are banks finally starting to face the music?  I know that spreads have widened back out again in the past month.  But the market price of the CDOs that Merrill Lynch puked for 22 cents did not drop from 40 cents at the end of the quarter to 22 cents two weeks later when Merrill sold them.  Merrill had these assets marked too high.  The same is probably true for some of the assets that Lehman holds in Level 3.  No market exists for these securities unless Lehman is willing to unload them at highly distressed levels and take a large loss.
In any event, I think it is a convenient coincidence that the brokerage analysts cut their estimates right after the SEC's naked short sale ban expired.  It was wise to wait until it was no longer a major inconvenience for hedge funds to short these stocks again.  That way, when various magazines are handing out analyst awards for great calls, analysts can say they had the timing right.  Maybe by then investors will conveniently forget that most analysts were estimating brokerage firm profits for the past three quarters before having to slash those estimates two weeks before the earnings announcements to avoid looking foolish.  The fact that investors still pay attention remains a mystery to me. 

Countrywide Option Arms Continue to Deteriorate Significantly

Countrywide Financial, now part of Bank of America, released some rather alarming information about its option arm portfolio, which represents 28% of total mortgage loans it holds for investment.  According to a regulatory filing made yesterday, thousands of borrowers with $25.4 billion in option arms owe as much as their homes are worth.  One in eight is at least 90 days late on payments.  As of June 30th, the typical borrower owed 95% of the value of his home, up from 76% when the loan was made.  The drastic increase in loan-to-value ratios on these loans stems partly from precipitous declines in home values in Southern California, where Countrywide is based.  The fact that 72% of borrowers were making less than full interest payments on their mortgages merely compounds the problem.  This implies that 72% of the borrowers will not be able to afford the inevitable increase in their mortgage payments when they are required to pay the full interest and principal due.  Furthermore, borrowers are adding to their debt burden as the negative amortization causes the principal on their mortgages to increase.  The increase in principal coupled with declining home prices are a lethal combination.  As homeowners face the prospect of owing more on their mortgages than their homes are worth, they are more than likely to hand the keys to the bank.  For more depressing statistics on the looming option arm disaster, you can read my recent post on the topic.  It includes a very handy chart from the Wall Street Journal that is worth my yearly subscription rate.    

Tuesday, August 12, 2008

UBS to Split Units as Wave of Customer Defections Point to Loss of Confidence

UBS reported a second-quarter loss of 358 million francs ($331 million) and announced a separation of its investment banking and wealth management units.  The Swiss bank's quarterly loss seemed rather benign but would've been worse had it not had the benefit of a 3.83 billion franc tax credit.  The most disconcerting part of the earnings announcement was the increase in customer withdrawals.  Wealthy clients from its private bank withdrew 17.3 billion francs in the quarter, a sharp increase from the first quarter, when the company experienced 12.8 billion in withdrawn customer funds.  UBS seems to think that its reputation might be restored if clients from the private banking are insulated from the negativity associated with the $42 billion in writedowns (at last count) over at the investment bank.  Furthermore, since the underwriting business is not what it used to be, perhaps it can book some investment banking fees by orchestrating an elaborate spinoff later.  However, it doesn't address the reputational issues plaguing the private client unit itself, such as the auction-rate securities debacle and the Justice Department investigation related to tax evasion.  My advice to UBS?  Keep running those catchy U and US, UBS commercials on CNBC, but for the love of God stay out of the headlines.  

Wachovia Post-Announces Wider Second Quarter Loss

If you didn't think $8.86 billion was enough of a quarterly loss for Wachovia, you're in luck!  The bank announced that it was increasing its second-quarter loss by $500 million pretax to reflect a hit it is likely to take from a settlement with regulators of the auction-rate securities probe.  The new and improved second-quarter loss is $9.11 billion, or $4.31 a share.  When Wachovia originally reported its second-quarter earnings, the stock posted a monster rally because losing $8.86 billion seemed like chump change at the time to investors, despite the fact that analysts were expecting the company to post a profit.  In any event, there's always the third-quarter to look forward to, the third-quarter pre-announcement, actual announcement, and quite possible post-announcement. 

Monday, August 11, 2008

Corporate Credit Unions Face Mounting Paper Losses From Mortgage Assets

The Wall Street Journal reports this morning that five of the largest credit unions are reporting paper losses on mortgage holdings large enough to wipe out all of their equity.  The credit unions respond that the losses are merely temporary and that they fully expect for the market to rebound.  This belief is commonly referred to as "we'll-make-it-back-as-soon-as-we-pull-our-heads-out-of-the-sand" syndrome. In fact, two corporate credit unions, Western Corporate and U.S. Central have have gone so far as to reclassify some of the assets on their balance sheets from "available for sale" to "held to maturity."  Assets classified as "held to maturity" can be carried on the books without reflecting temporary swings in asset prices.
Furthermore, the federal credit union regulator, the NCUA, is planning an accounting rule change to allow corporate credit unions to more clearly highlight the funds they hold from regular credit unions on their balance sheets.  Certain funds from regular credit unions, which are currently excluded from the balance sheet, are apparently a key source of capital.  This begs the question of why they were never included before.  But, when in doubt, just reclassify assets and have your regulator change a few accounting rules to tidy up those balance sheets.  These solutions work perfectly fine in a static world where people aren't panicking about losing their money in the next financial firm failure.  However, when the name of your credit union is reported in a front page story in the Wall Street Journal right next to the words "negative equity", a few of your depositors may decide they don't want to wait around for those paper losses to rebound.  This is precisely how temporary asset price declines can become permanent.  Although credit union deposits are insured up to $100,000, providing some comfort to depositors, this fact didn't help IndyMac one bit.  The last time a corporate credit union failed was in 1995 and the regular credit unions who had their funds with the corporate credit unions eventually recovered their money.  The NCUA's director of the office of corporate credit unions claims that the possibility of a corporate credit union failure is "so remote" that "I can't even imagine that happening."  If one of our regulators thinks there's nothing to worry about, I'm certain he's right.  After all, regulators saw this mortgage mess from a mile away. 

Friday, August 8, 2008

Deutsche Bank in the Casino Business

With Las Vegas casino revenue down for five straight months, perhaps this is not the best time to enter the casino mogul business.  Unfortunately, Deutsche Bank has had little choice but to foreclose on the $3.5 billion Cosmopolitan Resort & Casino in Las Vegas.  The bank attempted to sell the unfinished complex after 3700 Associates LLC, led by Ian Bruce Eichner, defaulted on a $760 million construction loan in January.  Deutsche Bank is in talks with companies including MGM Mirage and Hilton Hotels to help run the 80,000 square foot casino.  Bringing in a partner would allow Deutsche Bank to avoid having to obtain a Nevada gaming license, which is apparently not an easy process.  Deutsche has continued to fund construction on the 8.5 acre development which includes two high-rise towers, three wedding chapels, a sandy beach overlooking the Strip and a deck featuring "European-style bathing."  I must admit that this place sounds great, albeit in a very over-the-top-what-happens-in-Vegas-stays-in-Vegas kind of way.  However, it is likely that the bankers will cut some glitzy corners in order to keep the project on budget.  The interesting question remains: What does a German bank know about building and operating a casino?  If you consider the stock market to be the largest casino in the world, perhaps there is hope for this project after all.  

UBS and Merrill Pay to Make it Go Away

Following Citi's lead yesterday, UBS settled with federal regulators in the auction-rate securities probe.  UBS has agreed to pay $150 million in fines and will bailout retail investors (details are yet to be announced, update to come).  Merrill Lynch has also announced that it will buy back auction-rate securities from its clients over a one-year period beginning January 15, 2009.  The total amount that Merrill will repurchase is expected to be between $10 and $12 billion.  I'm certain that other investment banks who sold auction-rate securities to retail investors will more than likely follow suit.  Sometimes it is just easier to pay to make a problem go away than risk damaging your reputation with clients.  In the grand scheme of things, paying a $100 million fine and maybe a couple of hundred million more to eat losses, is really a drop in the bucket when you are losing billions of dollars a quarter in MBS, CDOs, CDS...etc.  Furthermore, you don't want to lose your loyal retail investors because you will need them when the next bubble rolls around in another couple of years.  It's much easier to pump and dump when you have "dumb money" in the kitty.  The "smart money" falls for the routine too, but they usually can't get away with suing you because they were an "unsuitable" investor.  They are just more than likely to yank their money because they are mad and take it to another broker, who is going to do the exact same thing.  But the "dumb money" is loyal to a fault, as long as you keep bailing them out...   

Update: Details of the UBS settlement with the New York AG, the Massachusetts Securities Division and the SEC: UBS will buy back $8.3 billion in securities from private clients for two years starting Jan 1, 2009 and $10.3 billion from institutional investors starting June 2010.  It will pay the $150 million fine without admitting or denying guilt.  UBS estimates it will cost $900 million, which will be booked in second-quarter results.

Fannie Mae Posts More Losses, Cuts Dividend

Fannie Mae posted a net loss of $2.3 billion, excluding preferred dividend payments, and said it would slash its dividend by 85 percent.  The mortgage lender booked $5.35 billion in credit-costs as it increased loan loss provisions and charge-offs.  One would think that investors could no longer be surprised by the magnitude of Fannie's losses after the recent precipitous plunge in the mortgage lender's stock and the disappointing losses reported by Freddie Mac yesterday.  Yet the stock is down another 14% in pre-market trading, so apparently someone was surprised.  According to CNBC, 49% of the losses came from Fannie's Alt-A portfolio of mortgages.  I wrote about Fannie Mae's $344.6 billion in Alt-A exposure on May 7th, and wondered at the enthusiasm surrounding Fannie's last earnings report.  I felt that the company had enormous exposure to losses from Alt-A's given how poorly those assets are performing and considering the amount of leverage that Fannie employs.  The good news is that Fannie's debt is now officially guaranteed by the US taxpayer which protects the rest of the banking system from catastrophic losses due to a Fannie Mae default.  It is growing increasingly likely that Fannie will be sporting some fresh capital that is also guaranteed by the US taxpayer, which doesn't help Fannie's current shareholders, but will keep the housing market from complete and total collapse due to a lack of financing.  Nevertheless, if financials can rally in the face of this awful news, then maybe we really have found the bottom.

Thursday, August 7, 2008

Citi Forks Over $7 Billion to Settle Auction Rate Securities Probe With New York Attorney General

New York Attorney General Andrew Cuomo has announced a settlement worth more than $7 billion with Citigroup.  The settlement requires that Citigroup buy back securities from retail customers, charities and small to mid-sized businesses by Nov 5th.  Hello, third quarter $7 billion writedown!  Actually, the settlement requires that Citi buy back $7 billion in auction rate securities from its retail customers and compensate those who sold them at a loss as well as pay a $100 million fine.  According to Citi, losses should be less than $500 million.
If you disregard Citigroup's remaining CDO portfolio, which it now has to mark down thanks to John Thain's bulk CDO pukage announced last week, things are really looking up at Citi.  If you pay no attention to all of the risk remaining in Citi's home equity, mortgage and credit card portfolios which are certain to deteriorate with the economy, we've definitely found a bottom.  If you chose to ignore all of the remaining litigation risk from the civil suits that will be filed on behalf of institutional investors because of this settlement, despite the fact that they "neither admitted nor denied guilt", can you afford not to buy Citigroup's stock?
It's times like these that call for action.  It's been some time since I have been inspired to concoct an imaginary Vikram Pandit conversation.  For your enjoyment, the following is my interpretation of what may have occurred when Vikram Pandit hammered out a settlement with Andrew Cuomo: 

Andrew Cuomo:  We have some pretty damning evidence that your sales force was instructed to pump auction-rate securities once Citi stopped supporting the market.

Vikram Pandit:  Could you excuse me for a second? I have to take this call.  (Into phone)  Tell them we won't do it for less than 44 cents with 60% financing. (pause) What???  22 cents and 75%?  Ok, tell him he's done on $10 billion.  Ask him where he'll do another $10 billion and call me back! (Hangs up phone)

Andrew Cuomo:  Mr. Pandit.  Put the phone away. You're facing some very serious charges!

Vikram Pandit:  How much do you want?

Andrew Cuomo:  Excuse me?

Vikram Pandit:  How much money do you want and do you need any financing?

Andrew Cuomo:  Are you admitting you're guilty?

Vikram Pandit:  Yes. Absolutely.  Now how much do you want?  Would you like $20 billion?

Andrew Cuomo:  Can you afford a settlement that high?  Won't that threaten your solvency?

Vikram Pandit:  Perhaps.  Yes, you may be right.

Andrew Cuomo:  Perhaps something around $7 billion is more appropriate?

Vikram Pandit:  Perfect!  Will you take CDO's as payment?  The notional amount is around $30 billion.  They're bound to bounce back, after all, they are AAA rated.

Andrew Cuomo:  Absolutely not!

Vikram Pandit:  Ok, not a problem.  I can always get a loan from the Fed against something we own.

Andrew Cuomo:  I'll schedule the press release.

Vikram Pandit:  I won't be able to attend, I have a meeting on an important matter.  (speaking into his phone again)  What?! 18 cents and 80%? (pause) Done!  Ask him where he is for another $10 billion.

Option Arms Chart Signals Looming Disaster

The Wall Street Journal had a fascinating story yesterday about FirstFed Financial,  a small bank based in California that focused its lending efforts on option arms to credit-worthy borrowers.  Although the bank had been heralded for its pristine underwriting standards in the past, FirstFed had lowered those standards during the housing boom to avoid losing business to competitors.  FirstFed is now facing a spike in delinquencies that is rivaling levels seen in subprime.  Forty percent of FirstFed's borrowers became at least 30 days delinquent after the payments on their adjustable-rate mortgages were recast.
For those who aren't familiar with option arms, these loans have an initial teaser rate that is significantly below the market rate.  The borrower has several options when he gets the bill every month.  The variety of choices reflect either payments towards principal, the market interest rate or merely the teaser interest rate.  The lowest payment allowed by the loan typically does not cover principal and often does not even cover the interest due, the balance of which is added to the principal amount, leading to negative amortization.  At some point, the borrower is forced to make full payments of principal and interest, either when the loan resets after a preset period (typically five years) or when the principal balance on the loan hits a preset amount (typically 110% to 125%).  When these loans reset, monthly mortgage payments can increase by 60% or more, causing credit-worthy borrowers to begin defaulting at subprime rates.
I have written about option arms ad nauseam here, particularly when I am discussing Washington Mutual and Wachovia, banks which have enormous exposure to these toxic loans.  But sometimes a really good chart is better than words.  What I found most disturbing about the chart is that we haven't even begun to see the bulk of these loans recast.  The second half of 2009 is when it starts to get really ugly, with roughly $30 billion in loans per quarter resetting to higher rates.  How many of those borrowers can really afford spikes of 40-60% in their monthly mortgage payments?  I'll let you mull that one over...    

AIG: What's Another $5.36 Billion?

AIG reported a loss of $5.36 billion, or $2.06 a share in the second quarter, significantly worse than average analysts estimates.  Why the analysts had this one so wrong is anybody's guess.  It is widely known, and has been reported several times here at Mock The Market, that AIG has a monstrous portfolio of credit default swaps.  As of the end of June, AIG guaranteed $441 billion of assets, $57.8 billion tied to subprime, down from $469.5 billion and $60.6 billion respectively as of March 31.  Note that the subprime number has barely declined, indicating that the company is trying to dispose of the most liquid assets first, hardly a good sign.  If you are an analyst following this stock and aren't keeping track of what is going on in the credit default swap market, you are not very good at your job.  Frankly, I don't care how good the insurance business is, until AIG figures out a way to mitigate the risk in its derivatives portfolio, the company will continue to post losses until the credit markets return to normal.  First, find the bottom in housing, then find the turning point in credit, then put out a rosy report on the company's prospects.  Hear that, Mr UBS analyst who thought this was a "buy" two days before this disastrous earnings report?
AIG wrote down the value of credit-default swaps by $5.56 billion in the second quarter.  Even more disconcerting, the company has had to post $16.5 billion of collateral as of July 31st and said it is unable to determine the effect "that recent transactions involving sales of large portfolios of CDOs will have on collateral posting requirements."  What does that statement mean to me?  The company has no idea how much more money it will need to raise.  In the "yet even more disconcerting" department, AIG raised its estimate for how much it will have to pay on its swaps, from $2.4 billion to $8.5 billion.  AIG also marked down the value of investments by $6.08 billion after "severe rapid" drops in the value of securities backed by home loans.  The good news is that excluding the declines in the value of some investments, AIG only lost $1.32 billion!  What a relief!  The company only lost $1 billion in its core operations.  I smell another 330 point rally in the Dow.     

Wednesday, August 6, 2008

Ambac Earnings Report Requires Interpreter

Ambac reported net income of $823.1 million or $2.80 a share, catching nearly everyone by surprise.  Even my cab driver last night said to me "I don't know about that Manny Ramirez trade, but I know that Ambac is going to post a loss tomorrow!"  After reading several accounts of Ambac's earnings announcement for accuracy's sake, I was forced to confront the reality that it must be true.  Of course, excluding a non-cash gain that the company booked due to a decline in the value of its own debt, Ambac actually lost $1.53 a share, besting analyst's estimates of a loss of 61 cents per share.  That's better.  My head has stopped spinning.  I have returned from the alternate reality universe where the worst really is over. 

Freddie Mac Posts Loss, Cuts Dividend

Just one day after a 331 point rally in the Dow, Freddie had to come along and spoil everything by injecting a dose of reality back into the market.  The virtually-government-owned mortgage lender posted a net loss of $821 million or $1.63 a share, more than three times the size of average analyst estimates.  Credit-related expenses doubled from the first quarter to $2.8 billion and the company took a $1 billion writedown on subprime mortgages.  Freddie cut the dividend from 25 cents to 5 cents and restated its efforts to raise $5.5 billion of new capital.  Of course, raising capital will be significantly easier now that congress and the President have authorized Hank Paulson to buy unlimited amounts of equity in Fannie Mae and Freddie Mac.  With foreclosures on properties owned by Freddie increasing by 20% in the quarter, at least the government is going to get some hard assets for the money it is going to have to inject into the company.  Then, in the next fiscal stimulus package that is already percolating on capital hill, the government can send everyone a foreclosed property.  Even I have to admit that this would be a unique way to fulfill every U.S. citizen's wish to own his own home.   

Tuesday, August 5, 2008

Market Higher on Continued Declines in Commodities Prices

Commodities continue their recent sell-off, giving a boost to financials.  Lower commodities prices mean less inflation which takes the pressure off of the Fed to raise interest rates soon.  Higher interest rates would be yet another kick in the pants of the beleaguered banking industry.  As a consequence, each time commodities take another tumble, financials rally.  Furthermore, it is widely believed that many large hedge funds who have had success this year were long commodities and short financials.  If these players are unwinding their positions, this further reinforces the divergent movements between commodities and financial shares.
In the good news camp, analysts at UBS upgraded AIG this morning.  The stock promptly rallied in response to the upgrade, which I find amusing.  AIG reports earnings tomorrow.  Why on earth would an investor buy a stock the day before the earnings report just because some analyst at UBS, of all places, decided on a whim that this stock is a buy?  Is that because UBS knows subprime better than anyone?  UBS has certainly lost enough money in the past year because of its subprime exposure, so I suppose that could be the reason.  In any event, once again, without irony, this is reported in the financial press as if it were significant news.  Bloomberg even has the misleading headline "AIG Rises as UBS Upgrades to Buy on Narrower Losses" implying that the company has already reported narrower losses, which is certainly not the case.  Personally, I'm going to wait to hear the actual earnings report from the company itself.  Call me crazy but I don't have an particularly itchy trigger finger.
Meanwhile, in actual earnings news, D.R. Horton reported a wider than expected loss of $399.3 million or $1.26 a share.  Analysts were expecting a loss of 70 cents a share.  Wrong again.  The homebuilder took a $330.4 million charge for inventory impairments and other charges, Revenue dropped 44% to $1.43 billion, the number of homes closed fell 36% while net orders declined 56%.  Still searching for that bottom in homebuilders...   

Monday, August 4, 2008

Fed's Lending Facilities Subsidize Egregious Wall Street Executive Compensation

Thomas Montag just received $40 million to start work today as Merrill Lynch's new head of sales.  Mr. Montag is clearly a brilliant salesman, having negotiated such a rich deal from Merrill.  Not only has Merrill been forced to raise billions to replenish its capital as it has lost an insane amount of money in the past year, but the investment bank didn't even need to steal Mr. Montag away from a competitor.  Mr. Montag left Goldman in December and was presumably collecting unemployment checks from the government when Merrill's John Thain drove up in a Wells Fargo armored car filled with bars of gold and handed Mr. Montag the keys.
It seems that despite enormous losses, layoffs, incensed shareholders, government handouts, and the Fed's extreme generosity, Wall Street hasn't changed its tune.  Although bonuses are supposedly discretionary, banking executives continue to claim that it is necessary to compensate "talent" with millions of dollars in bonuses or risk losing them to competitors.  Frankly, shareholders should know this fact and anyone who views Wall Street compensation practices to be distasteful shouldn't own the stocks.  My beef is therefore not with the banks themselves, or with shareholders.  It is with the Fed.
Since the credit crisis began, the Federal Reserve has jumped through fire-rimmed hoops to concoct new lending facilities to keep the banking community afloat.  Without these lending facilities, it is my belief that several banks, in addition to Bear Stearns, would've collapsed under the weight of illiquid mortgage securities due to severe restrictions in the money markets.  Until the credit crisis began, the Fed never accepted mortgages (with the exception of agency pass-throughs) as collateral against its repo loans during open market operations with Wall Street.  The Fed couldn't accurately price mortgages and didn't want to be faced with the prospect of selling illiquid securities in the event of a default by a counterparty.  The beauty of a repo is that if the couterparty defaults on your loan, you can immediately turn around and sell the securities and be made whole.  When there is no market for the securities you are holding as collateral against the loan, you cannot recoup your money.  That is the precise reason why money markets froze last summer and have failed to recover.  Previously liquid securities have become less liquid and it is hard to determine where securities would be liquidated in the event of a default.  The Fed is now assuming that liquidation risk as it enters into repos using questionable collateral.  Furthermore, the Fed has lowered interest rates a number of times in the face of rising inflationary pressures, also in an attempt to bail out the banking sector, and is offering loans to Wall Street on illiquid collateral at roughly 2%.  Initially these lending facilities were supposed to be temporary until credit markets thawed.  But the Fed just extended them through January 2009.  In my opinion, as Wall Street's new regulator, the Fed had (and probably still has) a unique opportunity to make a bold statement.  In return for access to the discount window, the TAF and the TSLF, Wall Street should not be allowed to pay out cash bonuses until the "temporary" lending facilities cease to exist and the Fed is no longer exposed to potential losses from its illiquid holdings.  If shareholders want to continue to throw money at these institutions that have continually misled them about the risks on their balance sheets, that is fine with me.  But being on the hook as a taxpayer for a bank failure that could cause the Fed to take losses immediately after Wall Street paid out record bonuses in 2007 really pisses me off.  If Mr. Bernanke wants to avoid looking like a shill for Wall Street, he needs to step up his game.  If we're going to socialize the losses, we should get some protection.  It is incredibly hard for me to believe that banks are even considering paying out bonuses in the face of enormous losses.  But a $40 million guarantee to a new hire that has yet to make a penny for a bank that just posted $10 billion worth of losses in the past two weeks is evidence that the culture hasn't changed.
It has been a year since Jim Cramer went off his meds and ranted on CNBC about the Fed needing to open the discount window.  Bear Stearns proceeded to pay out $3.4 billion in compensation for 2007, a 21% decline from the prior year, despite a 94% decline in net income from the prior year and then went bust a few months later.  Some believe that had Bernanke opened the discount window earlier, Bear would still be around.  I believe that had the bank preserved some cash by not paying out bonuses, it might still be around.  I'll let my readers draw their own conclusions.  For nostalgia's sake, I'm including the Crazy Cramer video.  Enjoy...  

Friday, August 1, 2008

GM Loses $15.5 Billion in Second Quarter

General Motors managed to surprise investors with a $15.5 billion second-quarter net loss, despite its mid-July warning that it would post "a significant second quarter loss."  Analysts believed the word "significant" meant a couple of measly billions, as they were expecting a loss of around $2.62 excluding some items.  GM's actual net loss of $27.33, or $11.21 a share excluding items, could be characterized as significant by an optimist.  I would suggest using the term "catastrophic".  The automaker took $9.1 billion in charges and write-downs in addition to suffering a  steep drop in revenue of 18%.  Both Ford and GM have followed Chrysler's lead in curtailing leases offered on SUVs and trucks.  These recent announcements are meant to stop the bleeding in their lending operations as automakers are taking losses after leases expire and they are stuck with trucks and SUVs that consumers no longer want because refueling costs $100 a pop.  Unfortunately, a consequence of the decision to stop offering leases on trucks and SUVs will be to further reduce sales.  
Can the US auto industry survive this downturn?  Frankly, that is a very tough call and I believe that it can't survive in its current form.  The US consumer is depressed and out of steam.  The days of tapping home equity loans to buy a new car every two years are over.  Getting a lease on a fancy car that you can't afford to buy is no longer an option.  I'm sure our lawmakers are already plotting another economic stimulus package.  No economic stimulus package can change the fundamental problem that the last few years were a financing phenomenon of too much easy credit to too many people who couldn't actually afford it.