Tuesday, September 30, 2008

Libor Leaps Higher As Banks Continue to Hoard Cash

Overnight Libor settled at 6.88% in London and three-month Libor leapt another 20 basis points to 4.05%, indicating continued severe dislocations in the money markets. I reiterate my "ZOINKS!" from the day before. Never have I seen the Fed work its liquidity pump so hard to to so little avail. It appears as if the Fed has lost all control of the money markets as the global banking community runs around in circles with its hair on fire. It makes you wonder why anyone would think that another interest rate cut can possibly help the frantic situation.

The banking bailout dujour was a $9.2 billion injection by the French and Belgian governments into Dexia, the world's biggest investor in local governments. In addition to arranging loans for municipalities all over the world, Dexia also insures US municipal bonds. If you are an owner of US munis, you may want to send your friends in France and Belgium a thank you note for bailing you out.

Speaking of bailouts, the Senate has vowed to pass the bailout bill tomorrow. Equity futures are supposedly rallying on the hope that this will actually happen. No doubt another interesting trading day filled with volatility awaits us all.

Monday, September 29, 2008

No Bailout, What Now?

Despite Paulson, Bernanake, and Bush's assertion to Congress that the world would implode if a bailout bill wasn't passed, the bailout bill failed to pass. Although close, the House voted the bill down 228-205. It seems as if some congressmens' constituents have bombarded their representatives threatening to pull their support in the upcoming elections. When it comes down to it, a choice between a collapsing world economy and a lost election is no contest for some lawmakers: a collapsing world economy wins every time. In response to the lack of a bailout bill (or perhaps just the neverending rash of horrendous news about bank failures, spiking money market rates, record hedge fund redemptions etc.), the market absolutely crumbled with the Dow, S&P, and Nasdaq all down between 8% and 10%.
Rest assured, the bobbleheads on CNBC were back proclaiming that this was a PR problem and that the average American was just not smart enough to understand that a bailout of Wall Street is absolutely necessary for Main Street to continue to function. You see, small businesses and companies won't be able to pay their payrolls. If the average Amercian really understood the commercial paper market, which they don't because they're just too stupid, then they could grasp that buying toxic assets from overleveraged banks that made moronic investment decisions while paying their executives billions of dollars in compensation is the only way to insure that your local seven eleven can meet its payroll. Frankly, I propose that if the government wants to bail out main street, it should just bail out main street. Open up the discount window to everyone. Or, the government can buy every single empty house sitting on the market and create a squeeze in the housing market so that supply is constrained and housing prices can go back up. I can think of at least fifty more crazy ridiculous things that the government could spend $700 billion on that would be stimulative to our economy that does not include helping insolvent banks stay in business while saddling the US taxpayer with potential losses. So I'm glad the stupid bill didn't pass. I don't think it is the answer and I'm tired of all of the BS being tossed around that it is the only solution. I think the market is going lower regardless of whether we get a bill because the market largely underestimated how devastating a large simultaneous rush to the exits by every levered investment vehicle on the planet would be. Massive delevering explains why the nasdaq, an index largely populated by tech stocks that although cyclical, don't rely on the credit markets, was indiscriminately pummeled today. I suspect the Fed will probably lower rates if things get much worse. A lowering of interest rates, however, doesn't seem to be the answer either, as the Fed had to inject over $600 billion in the money market just to get the flow of funds moving again. So I'm crawling back in my bunker. Somebody call me when the VIX hits 60. I might buy a share of stock or two.

Fed Pumps ANOTHER $630 Billion Into Money Markets

The Fed doubled its swap lines with foreign central banks by $330 billion to $620 billion. The US central bank also tripled the size of the Term Auction Facility (28 day loans) from $150 billion to $450 billion. To quote an old friend named Scooby Doo: "ZOINKS!" Clearly the inevitability of the passage of the bailout bill has done nothing to ease the strains in the money markets. Banks are terrified to lend to each other, understandbly since the possibility of another banking failure increases by the minute. The question remains: If the Fed had to inject an additional $630 billion into the money market TODAY alone with little result, what makes anyone think that a $700 billion bailout bill that won't go into effect for weeks will help asuage the panic in the market? I don't know about you, but I'm staying in my bunker with some canned goods. Somebody let me know when it's safe to come out.

Citigroup Acquires Wachovia Banking Operations, Profit-Sharing With FDIC

Citigroup will acquire the banking operations of Wachovia and enter into a profit-sharing (or rather loss-sharing) agreement with the FDIC on the future performance of $312 billion in loans on Wachovia's books. Citigroup has agreed to assume the first $42 billion in losses on the loans with the FDIC responsible for the rest. In return the FDIC is getting $12 billion in preferred shares in Citi to compensate the federal agency for assuming the risk. Frankly, I'm not sure $12 billion in crappy Citi preferred is worth assuming $270 billion in downside risk on a portfolio of mortgage-related assets but I'm not going to knock the FDIC. I'm still impressed with Sheila Blair for making $1.9 billion on the WaMu seize-and-flip to JP Morgan. Maybe we should put her in charge of the Bailout Fund. In any event, bondholders are happy as Citi has assumed Wachovia's senior and sub debt. Equity holders appear to be wiped out. Now that the Wachovia issue is resolved, we move on to the next question: Who's going to bail out Citigroup?

Sunday, September 28, 2008

Uber-Bailout Weekend

Lawmakers have reached an agreement on the the $700 billion bailout bill, which is expected to go to a vote tomorrow. Although filled with many provisions to "protect the taxpayer" and offer relief to borrowers in danger of losing their homes to foreclosure, the bill grants significant discretion to the Treasury to determine pricing of the assets. The Treasury has 45 days to issue guidelines on the composition and pricing of assets the government intends to buy. Meanwhile, 45 days is nearly a lifetime in this market. Banks and lenders are dropping like flies all over the world. B&B, the UK mortgage lender that was instrumental in financing the housing boom in the UK, was nationalized this weekend. Fortis NV, recieved $16.37 billion in loans from The Netherlands, Luxembourg and Belgium after BNP Paribas and ING walked away from buying the company. Germany's Hypo Real Estate Group may need a rescue by German banks this weekend. In the US, the Wall Street Journal is reporting that Wachovia is in advanced talks to sell itself to either Citi or Wells Fargo. The Journal article states that the government is involved in negotiations, without offering details of which agency is brokering the deal. I suspect that if the government is involved, Wachovia shareholders will not be getting a premium for their shares. Wachovia had stated several times last week that it had ample liquidity and didn't need to hurry to do a deal. Of course, WaMu was making the same hollow claims the day before it was seized by the FDIC. A deal will most likely be struck before the opening bell tomorrow morning.
What to make of all the frantic activity over the weekend? Clearly, the credit contagion is spreading rapidly and taking the weakest players down in a furious wave. It seemed as if the market had grown accustomed to one, maybe two banking failures, conservatorships, or shotgun mergers in a weekend. This weekend we had three bailouts in Europe and one probable takeunder in the US. Is this bailout plan really going to make a difference? By the time it is implemented, we'll have three banks left and the central banks around the world will already own the rest. If Mr. Paulson doesn't get the plan off the ground soon, he'll find it's too late to buy the assets because the government will already own them.

Watered-Down Government Bailout Package Close To Completion

Although the bailout plan has not been finalized, lawmakers claim they will have a deal by Sunday night. The plan has been modified significantly from Paulson's original "Give me $700 Billion and don't ask any questions" proposal. You can read the full summary of the draft proposal on the Wall Street Journal's website. Some of the highlights include:
  • Cuts the plan in half from original $700 billion, with congressional review required for more funding
  • Gives taxpayers an ownership stake with participating companies
  • Puts taxpayers first in line to recover assets if participating company fails
  • Guarantees the taxpayers are repaid in full [intentionally vague?]
  • Allows participation from pension plans, local governments and small banks
  • Limits CEO compensation
  • Recovers bonuses based on promised gains that later turn out to be false
  • Allows government to facilitate mortgage modifications

This outline, which appears to offer significant protections to taxpayers, still lacks the necessary details related to pricing of the illiquid securities. After all, much disagreement exists over whether the goverment should pay "hold-to-maturity" prices versus "fair value." I suspect that allowing the government to take an ownership stake in the participating companies suggests that the government will pay above fair value prices for the illiquid assets, with expectations of making money on equity participation. The other key component is putting the government first in the recovery of assets if a participating company fails. It doesn't explain what sort of equity stake the government will take in pension plans or government organizations to help recoup potential losses from purchaing their illiquid assets. Furthermore, I don't understand why a pension plan (which should always hold assets to maturity) would need to sell assets at "distresses fire-sale" prices. But I digress...

I do think this is a much better plan for taxpayers, which frankly is a relief, because it means that my head won't explode from the recent accumulation of steam. However, since this is a financial market blog, I will focus on how I expect the near-inevitable passage of the bill to affect the markets and whether it will do anything to restore order to the chaotic credit markets.

I don't believe that this plan is what the credit markets were hoping for. Because of the government's ability to take a stake in the participating entities, only banks that are in serious trouble will want to participate. Solvent institutions will not want to dillute their equity holders and panic their debtholders. Because the government's equity participation will now supercede every other creditor in bankruptcy court, expect distress in bond prices of senior secured obligations of banks that need this plan to ditch troubled assets. My suspicion is that Wachovia's debt, already trading at depressed levels, will be distroyed on this news. Furthermore, I don't believe that the market will interpret $350 billion as a big enough fund to resolve what is most likely a trillion dollar problem. The Fed is already financing over $350 billion in dodgy assets for banks that cannot obtain financing elsewhere because of lack of transparent pricing and counterparty risk fears. This plan doesn't seem to provide reassurance that all of those fears are misplaced, particularly given the UK's nationalization of B&B over the weekend, Fortis Investment's possible nationalization by the Dutch, and Wachovia's desperation to find a suitor before the FDIC comes knocking. I know that some have been calling for a big relief rally on news of a bailout package, but I suspect if there is a rally, it will be shortlived as reality of the enormity of the situation sinks in.

Friday, September 26, 2008

Vacation Alert

I am hopping on a plane in an hour to take a vacation (although I plan to post regularly next week).  Frequent readers know that when I go on vacation, some sort of banking failure or bailout ordinarily occurs so I thought it would be helpful to give everyone fair warning.  Last time it was Fannie and Freddie.  The time before, it was Bear.  I would've guessed that the FDIC would seize WaMu while I was on my flight, but they did that last night so the low hanging fruit has already been picked.  Rampant speculation is always welcome from readers.  Hope everyone can have a good weekend despite all of the scary news circulating about our financial system.

Thursday, September 25, 2008

Discount Window Borrowings Surge

Thursday afternoon's Federal Reserve balance sheet release was filled with painful evidence of how serious the liquidity squeeze remains for banks and dealers.  The significant increase in borrowing from the Fed would have been bigger news were it not overshadowed by the FDIC's seizure of WaMu and the fight over Paulson's $700 billion bailout package.  Primary dealers borrowed $105 billion from the Primary Dealer Credit Facility on September 24th, a shocking amount considering the stigma associated with borrowing from the discount window.  If you were curious why Goldman Sachs asked Warren Buffett for an investment or why the storied investment bank converted itself into a bank holding company, this is the answer.  Finding short-term financing is growing increasingly difficult and the Fed can't seem to create new lending facilities fast enough to keep up with demand for dollars.  Banks borrowed $72 billion from the new asset-backed commercial paper money market or mutual fund liquidity facility, a non-recourse loan facility offered to US depository institutions and bank holding companies to finance purchases of ABCP from money market funds.  The Fed is also accepting equities through the discount window, which I'm certain indicates that the financial apocalypse is upon us.  The loan to AIG has increased from $28 to $44 billion within a week.  I suppose AIG is still determined to pay off the loan and remain a non-government owned company, but it does not appear to be moving in the right direction.  The good news is, we still haven't lost any money on the Bear Stearns loan, although the last time the asset was valued was June 30th.  I'm awaiting the quarterly update and I'm assuming it is not good.
If the money markets don't thaw soon, and there is very little reason to believe that they will after WaMu's failure and the stall-out of the Paulson plan, the Fed will likely need another loan from the Treasury so it can increase its lending to the dealer community.  This is commonly known as running the printing press in a third world nation.  In the US, it's just Bernanke and Paulson doing what they do best; juicing up Wall Street so it can live to fight another day.  The Financial Times is reporting that Morgan Stanley lost close to a third of the assets in its prime brokerage last week (hundreds of billions of dollars) as hedge funds fled to rival banks.  The rumor circulated all last week, but was only published as news in a major financial publication for the first time tonight.  This is yet another unintended consequence of Lehman's failure.  Hedge fund clients are concerned that if Morgan fails due to the severe liquidity squeeze, they will wind up like Lehman's clients; unable to access their assets in a wildly fluctuating market.  Needless to say, concerns about the future of Morgan will likely hurt the market tomorrow.  At least this time, they won't blame the shorts.     

JP Morgan To Purchase WaMu Deposits

The WSJ is reporting that JP Morgan will purchase the bulk of Washington Mutual's operations. This is being billed as a "government brokered deal," although it is not expected to affect the FDIC.  Perhaps the Fed is granting yet another one of its generous Bear Stearns-like loans?  The Fed seems to like arranging these types of deals for JP Morgan.  Details of who exactly will be swallowing the losses from WaMu's $60 billion option arm portfolio will be revealed on the conference call at 9:15 pm Eastern.    

Update: JP Morgan is acquiring Washington Mutuals assets and deposits from the FDIC for $1.9 billion.  Reuters reports that the FDIC felt it had to seize the bank before Friday to quell customer anxiety fueled by media leaks.  WaMu had suffered an exodus of $16.7 billion in deposits since September 15th, leaving it with insufficient liquidity.  Shareholders and senior bondholders will be wiped out in the deal.  
Why do we need a $700 billion bailout when JP Morgan can just buy every ailing bank?  Seriously, this is a fine example of why we shouldn't allow the government to pay "hold-to-maturity" prices for assets.  In this situation, a bank failed, and a healthier bank was willing to purchase the assets and deposits.  Shareholders and bondholders were wiped out, depositors were saved, and JP Morgan assumed the remaining risk in WaMu's portfolio because it purchased the assets at what it determined was a good price.  This proves that investors are willing to make opportunistic acquisitions at the right price.  Paulson and Bernanke's idea of buying assets from banks at prices above fair value would be a money-losing proposition.

Equity Investors Cheer Bailout Plan?

Financial headlines today were disappointing enough that a rational investor would expect the stock market to be lower.  After all:

However, equity markets are up, supposedly cheered by the fact that the $700 billion bailout package will most likely pass.  President Bush urged lawmakers to pass the bailout plan claiming that the entire "economy is in danger" and the only way to rescue the economy is to invade the country and liberate its citizens.  Oh, sorry, I was reading Mr. Bush's last speech where he claimed that the US was in danger and we must act quickly to enact his administration's plan or face grave consequences.  
Although it's true that the US economy faces a rough road to escape from the debilitating cycle of banks who cannot lend because they are suffering under the weight of losses on underperforming assets, what the bailout plan is proposing is a reallocation of those losses.  If we let the market sort out this mess on its own, losses from the mortgage mess will be allocated to equity investors in insolvent banks first, followed by the preferred holders, and finishing with the bondholders.  Financial services professionals will suffer job losses and huge curtailments in their incomes.  Finally, taxpayers will pay when the FDIC has to be recapitalized to cover all of the banking failures and liquidations that will ensue.  Frankly, I prefer this scenario.  Why?  Because it allocates the losses in the same manner in which it allocated the gains on the way up.  This is how our capital markets were conceived and I find it very disturbing that our administration seeks to change our core beliefs in capitalism.  It threatens the integrity of the capital markets as it benefits those who caused most of the problems to begin with.  Asking the US taxpayer to pay for lending mistakes made by people who were paid exorbitant sums of money, and to bailout stock market investors from lousy investment decisions despite the fact that they should know they are taking risk when they buy stocks, is flat-out unfair regardless of how much it is going to "boost the economy".  We might as well spend $700 billion to buy all the foreclosed houses and give every homeless person in America a free place to live.  It's the same thing.  Sure it would boost the economy, as the homeless would now need to buy furniture and that would be great for Home Depot.  It would also be rewarding a group of people, who many would argue are on the street because they abuse drugs or are too lazy to get a job, at the expense of ordinary hard working citizens.  Because the Bush administration is proposing the idea, it happens to benefit the banks and not the homeless.  But the market should make the decision, not the government. 
Offering to buy securities from insolvent banks at potentially inflated prices, (Mr. Bernanke thinks they are "fire-sale" prices, but he really has no idea what they are worth) is a transference of risk of future losses from equity holders to the US taxpayer.  Furthermore, it is endangering the US dollar as a reserve currency for the world by asking the world to lend it yet another $700 billion dollars.  Although the bailout plan may provide a brief boost to the banking sector, it may easily cause a currency crisis in the US similar to what emerging markets have experienced in the past.  In the face of all of this, it seems absurd that stocks are rallying.  However, since Chris Cox says you can't short 'em, everyone who understands the dire consequences of this extraordinary action by our government is not allowed to express their views by shorting stocks.  Most of the people who understand what is happening work in the bond market and are cowering under their desks because they can't find anyone in the formerly friendly money market to lend them money for more than a week at ANY rate above libor.  The credit markets are still panicked despite the fact that we are close to a $700 billion deal, yet the equity market is up nearly 2%.  I've seen some crazy markets in my time, but nothing, absolutely nothing comes close to the past two weeks.    

Wednesday, September 24, 2008

FBI Investigating Fannie, Freddie, Lehman, AIG For Fraud

The FBI has launched preliminary probes into whether accounting fraud occurred at Fannie Mae, Freddie Mac, Lehman and AIG.  Although I personally believe that the FBI's time is better spent chasing gang bangers, I suppose if the SEC isn't going to do its job, somebody has to pick up the slack.  After all, gang banging has died down significantly since Tupac and Biggie offed each other in the '90s and Diddy went all soft.  While the SEC works to tweak its "temporary" short-sale ban (IBM added itself to the list today, options market makers now exempted etc), perhaps somebody will finally figure out if accounting fraud was perpetrated at these firms by the executives who were paid very handsomely during the boom.  If the FBI does find some fraud, perhaps the SEC will let us start shorting stocks again.   

Tuesday, September 23, 2008

Warren Buffett's $5 Billion Worth More Than Paulson's $700 Billion

While Hank Paulson and Ben Bernanke were busy explaining to Congress that the only way out of the mess they created was a blank check for $700 billion, Warren Buffett was working on a deal.  As the day wore on, stocks drifted lower as confidence waned that a working solution between lawmakers would be reached.  Then, Warren Buffett's $5 billion investment in Goldman Sachs was announced after the close and stock futures perked up.  Mr. Buffett will receive $5 billion in perpetual preferred shares that pay a 10% dividend and can be called at any time for a 10% premium.  Berkshire will receive an option to purchase $5 billion in GS stock at $115, exercisable within five years.  Naturally the market is up on this news.  The following are a few reasons why this is bullish news:
  • Warren Buffett is THE MAN.  He is a deep value investor and always picks the bottom.
  • GS is demonstrating investor confidence in the safety of its balance sheet and can raise money easily.
  • Warren Buffett is THE MAN.  Did I mention he always picks the bottom?
If you were more of a skeptic, you might wonder about the following:
  • Geez, isn't a 10% dividend a bit steep?
  • AND warrants on $5 billion of common stock with a strike price of $115 a share?  Isn't that roughly equivalent to giving away a 60 delta call option (worth around $2 billion) for nothing?
  • AND GS plans to issue $2.5 billion $5 billion  in common equity?
On one hand, the world's greatest investor just took a large stake in the bank.  On the other, the world's greatest traders just sold a five year in-the-money call option on themselves.  Which side are you going to take?  Well, if you believe that Mr. Buffett is giving you the signal to rush out and buy the stock, you're going to rush out and buy the stock.  If you think that buying GS stock is foolish because the equity will be worth less now that the company is paying a 10% dividend on preferred shares AND doing a dilutive equity issuance AND handing out call options on itself, well, you can sit around and watch the action.  Because you can't short the stock.  Thus, GS is up $10 after hours.  Isn't this market great?

Update:  GS doubles size of equity issuance to $5 billion.  Might as well take advantage of that short-sale ban...

Cox Vs. Paulson: Contradictory Plans?

With every US government agency frantically enacting drastic measures in the name of halting a full-blown financial crisis, it is interesting to ponder each agency's political agenda.  Predictably, Congress is hoping to save the ailing homeowners on the verge of foreclosure, an ever expanding voter block in an election year.  Bernanke is greasing the money markets, with little regard for the solvency of the institutions ("Whatever collateral they have, I'll take it!  Just give them a loan!")  The President is tasked with lifting the country's wilting morale by grinning and declaring that "Our economy is strong!" (just pull the string on his back and he'll say it again.)  The Treasury Secretary oversees bailouts, takeovers, raising capital for a government-run hedge fund, and ensuring that nobody gets confused about where he stands on the issue of moral hazard (equity is creamed but bondholders and counterparties are protected, unless you're Lehman, in which case, don't come cryin' to me, you bunch of pansies.)  The SEC Chairman, Chris Cox, is siding with equity holders by temporarily out-lawing short-selling.  The jury is out on how well any of these plans will work, save Mr. Cox's short-sale ban which is, um, not really going as planned.  Sure, the market rallied powerfully on Friday, only to give it all back on Monday, and demonstrated marked intraday volatility on both days.  Perhaps Mr. Cox should've spoken to a few market participants before enacting his plan (a singe derivatives trader? one hedge fund manager?)  If Mr. Cox is thoroughly confused as to why his plan has backfired so harshly, he might consider calling Mr. Paulson, who at least has some experience working for a Wall Street bank.  The conversation may go something like this:

Cox:  Hello Hank?  This is Chris.

Paulson:  Who?

Cox:  Chris Cox, SEC Chairman.

Paulson:  I don't know who you are, or which organization you're with, but I am a very busy man.

Cox:  Geez.  I'm head of the Securities and Exchange Commission!

Paulson:  Hmmm.  That rings a bell.  What do you want?

Cox:  I was wondering if you could maybe give me some advice on what to do about the short-sale ban.

Paulson:  A short-sale ban?  That's the dumbest thing I've ever heard.  It'll wreak havoc on the markets.  I wouldn't even consider something that foolish.

Cox:  Well, actually, it's already done.  We enacted the ban on Friday.  The ban goes until Oct 2.

Paulson:  WHAT?  

Cox:  Didn't you see the announcement in the financial press?  I was very pleased with the amount of coverage it received in the press.  Although, the response has not been as positive as I expected.  I just don't understand.

Paulson:  So you say the ban goes until Oct 2?  Can you hold on for a second? (puts Cox on hold and makes another phone call.)  Hey Bernie, I know this is supposed to be a blind trust and all since I'm Treasury Secretary but blue horseshoe says "SELL ALL OF MY STOCKS!"  You got that?


Monday, September 22, 2008

Morgan, Goldman Now Banks; Wachovia Left Out in the Cold

Both Morgan Stanley and Goldman Sachs lobbied the Federal Reserve to become bank holding companies over the weekend.  Their bid was approved by the Fed, ending the era of the independent investment bank.  Both Morgan and Goldman will now be subject to much stricter capital requirements and regulatory oversight.  Although the transition into a bank holding company will reduce their chances of making outsize returns on equity in the future, it allows them to remain independent. 
Morgan Stanley has apparently abandoned merger talks with Wachovia as it found Mitsubishi a willing investor in the firm.  Mitsubishi UFJ will pay $8.4 billion for a 20% stake in Morgan Stanley.  This leaves Wachovia out in the cold.  The bank still has problem assets it needs to unload and is searching for more capital.  Mr. Paulson better speed that plan through.  Too bad that investors who understand how bad this is for Wachovia can't short the stock...

Paulson Turns US Treasury Into Gargantuan Distressed Debt Hedge Fund

The details of Hank Paulson's plan to save the world financial markets from a systemic meltdown are being hammered out in Washington.  The plan calls for the Treasury to buy $700 billion in distressed assets from financial institutions.  Originally, Mr. Paulson proposed only buying mortgage-related assets but has widened the scope of assets to include credit-card debt, car loans, and unsold Hummers.  The part about the Hummers is a joke, but who knows how a desperate car company will interpret the "other devalued assets" phrase in the landmark proposal?  I am aware that the plan currently does not allow car companies to participate.  However, "any financial institution" is eligible to puke assets, a standard which has already been lowered once from "any financial institution headquartered in the US."  Frankly, I'm certain that car companies are lobbying to be included, since it is unpatriotic that the US would favor foreign financial institutions over US car companies.  
I am still waiting to hear more details about the plan before I can make judgements as to whether this is the most terrifying idea to be hatched by this administration.  Although it is true that this will help banks remove problem assets off of their balance sheets, if the prices on the assets from the reverse auction are much lower than where banks have them marked, it will require them to raise more capital.  In some cases, it may leave a few banks insolvent.  Whether private capital will be more likely to pump money into insolvent institutions after they have rid themselves of toxic assets is a big question, particularly when there is so much other great distressed garbage to pick through.  If it turns out that these assets are worth less than what the government pays for them, then the taxpayer loses.  This seems like a lose lose either way.
However, if belief in the plan's success is strong enough to restore a measure of stability to the financial markets, then that is at least a temporarily positive outcome.  Frankly, as I discussed in my rant about Chris Cox's ludicrous ban on short-selling, this is a fabulous opportunity for banks whose shares hit 52-week highs on Friday to issue more stock and raise capital.  Do not be surprised if we get a rash of equity issuance before the ban expires.  
The biggest concern on some economists' minds is how will the world handle $700 billion in additional treasury issuance that will go to finance the mother of all hedge funds?  Although some supporters are claiming that Mr. Paulson will eventually make money for taxpayers, the Treasurer still has to borrow $700 billion from the world through issuing Treasuries to finance this endeavor.  Frankly, of all the bearish views that I have ever spewed about the equity and debt markets, I have never doubted that US Treasury securities would always be considered the safest investment in the world, UNTIL NOW.  I am legitimately worried that this plan could cause a currency crisis in the US similar to that experienced by emerging economies in the past.  It is not a coincidence that foreigners have been net sellers of US assets recently.  I suspect this trend will only continue.  
For other interesting commentary on Paulson's plan, check out Calculated Risk and Naked Capitalism.  I'll have more thoughts as the ultimate plan is unveiled.

Sunday, September 21, 2008

Unintended Consequences of the SEC's Short-Selling Ban

Anyone who believes that the SEC's ban on short-selling was a positive development for the market should take a look at some compelling trading data from Friday.  While the US markets rallied over 3% on Friday, it was the result of a panic to cover shorts in financials, rather than renewed confidence in the US economy.  Some argued that Paulson's proposed RTC-like bailout of the banks was the reason behind the rally, but a look at price action in bank stocks tells a much different story.
Ordinarily staid bank stocks were behaving like internet stocks in 2000 with extraordinary trading ranges.  Zions Bancorporation (ZION) had a $92.44 trading range.  Yes, you read that right:  An ordinarily $50 stock ripped up to $131.20 before plummeting to $38.76 and then rallying back to $50.84.  Wachovia (WB) opened up 65% before selling off and closing up 30%.  Morgan Stanley opened up 50%, erased all of its gains, then rallied back to close up 20%.  What exactly is wrong with this kind of volatility?  You can ask the guy who paid $131.20 for ZION.  I guarantee that those trades weren't sent from hedge funds or mutual funds.  It was more than likely the result of some poor schmo retail investor that ordinarily sends market orders without suffering any real consequences.  This time he sent a market order and paid through the nose for it because there were not enough sell orders in the system to stop the stock from ripping higher.
A far better example of the dangers of manipulating stocks higher is exemplified by the Lloyd's Bank/HBOS merger in London.  After agreeing to purchase struggling HBOS the day before the short-selling ban was announced by the FSA in London, Lloyds took advantage of the artificial 20% rally in its stock by quickly issuing more stock to raise additional capital.  Any bank with half a brain will take advantage of the short-selling ban to raise new capital at these higher prices while only long investors can participate.  What do you think will happen to prices after the temporary short-sale ban is over?  Gee, I wonder.
Finally, banning options market makers from shorting stock shows a real ignorance of financial market function.  Options market makers carry tremendous inventories of options and stock that they constantly hedge in real time by buying and selling stock.  They rarely place directional bets on stocks and focus on risk management of their volatility positions.  They need to have the ability to short stocks in order to make markets for customers, otherwise they will have difficulty quoting options prices.  While regulators might believe they are preventing investors from expressing their bearish views through put-buying, they are also penalizing long investors who sell calls against long stock to juice returns (a practice referred to as buywriting.)  The options community is attempting to gain an exemption from the SEC.  If the SEC fails to grant an exemption, options markets in the 799 financial stocks on the list will be severely repriced, wreaking havoc on some market makers' ability to make markets in certain stocks.  Then maybe, someone can sit Mr. Cox down and explain to him how the market he is supposed to regulate actually works.
Frankly, all of the accusations that have been hurled at hedge funds and short-sellers blaming them for the collapse of Bear, Lehman, AIG etc. are absurd.  Mr. Cox continues to spout about the manipulation and malicious rumors that has led to these firms' demise.  Yet it has been six months since Bear Stearns collapsed, and the SEC has not filed a single charge against anyone for nakedly shorting Bear's stock, spreading malicious rumors, etc.  I have to ask what Mr. Cox has been doing this entire time?  If there were malicious rumors, I certainly would've found them by now.  How?  I'd go to every prime broker, subpoena the trading records, identify the buyers of credit default swaps, puts, naked-shorts in Bear Stearns, and then pull the tapes from the trading desks who talk to the hedge funds.  Every dealer is required to tape record their conversations and the SEC can simply ask for the tapes from every salesman at a Wall Street firm that had a hedge fund client that was shorting Bear through some bearish financial instrument.  Really, is that so hard?  The SEC should start punishing all of the manipulators and abusers if they exist.  Instead it has chosen to greatly distort financial markets by penalizing every player in the market.  Mr. Cox needs to be very careful that he doesn't ruin the integrity of the US financial markets in his quest to go after a few (if any?) bad apples.          

Friday, September 19, 2008

SEC Temporary Short-Sale Ban Official: Capitulation or Manipulation?

It's official.  Chris Cox is insane.  He has chosen to follow in the footsteps of the loons at the FSA in London and put in place a temporary ban on short-selling of financials.  The ban extends to 799 financial institutions including banks, broker dealers and insurance companies.  The FSA's ban on short-selling on financials in the FTSE 100 has caused the mother of all short covering rallies on the FTSE 100, which was up around 8% the last time I checked.  I suspect there will be significant dislocations in the US markets as investors scramble to cover shorts.  The ban on short-selling offers a few exemptions, most notably to market makers in the stocks and investors who take on short positions due to an options expiration.  It doesn't, however, exempt options market makers beyond today's trading day.  By the way, did the SEC or the FSA know it was options expiration friday?  You'd think the regulators would have the sense not to impose a rule change of this magnitude effective immediately on a FRIGGIN ' OPTIONS EXPIRATION FRIDAY of quite possibly the most volatile week of trading the market has ever seen.
First, a wee bit of criticism, then I'll get to some predictions.  I firmly believe that short-sellers provide an invaluable pool of liquidity to the market.  Being a successful short-seller is extremely risky and difficult to pull off.  Short-sellers tend to be investors that dig deep into financial statements and root out fraud.  It was short-sellers that identified Enron as a ponzi scheme while all the Wall Street analysts, mutual fund investors, and the media were praising the company without asking difficult questions.  The market needs cynics.  Stocks are risky.  It is absurd to attempt to manipulate the stock market higher when the fundamentals of financials are so poor.  Is it true that investors were attempting to short the dealers in the past few days?  Absolutely.  Why?  Because the money markets were no longer willing to lend and dealers need the money markets to survive.  Did Mr. Cox and the other clowns at the SEC know that primary dealers borrowed $59 billion from the discount window yesterday?  That facility that no bank wants to admit to borrowing from because it is a lender of last resort and indicates the firm has run out of financing options?  You see, broker dealers have very risky business models.  You'd never actually know that if you listened to Wall Street analysts who continually forecast smooth earnings growth for them despite the fact that they operate in an extremely cyclical business environment.  Owning brokerage stocks is a risky proposition and investors need to fully understand the risks they are taking.  Owning banks and insurance companies has also been risky as of late because of the ridiculously loose underwriting standards that the industry allowed for so many years.  Short-sellers were short these stocks because they took the time to identify the underlying risks in the business and understood how toxic the assets on their balance sheets were.  The mutual funds and pension funds who are long these stocks should be ashamed of themselves for just believing that the stocks were cheap on a price to book basis, without caring enough to understand that the book values were grossly overstated.  So now, we're going to bailout equity investors?  Why?  Because the Dow was down 20% on the year?  Mr. Cox doesn't think that is justified given that financial firms have taken $500 billion in write-downs?  
My predictions are that we do get a huge rally in the market (obviously, futures are already up significantly.)  Furthermore, we will get crazy dislocations on specific stocks that have been actively shorted lately.  Some financials will be up 50%, 60%, maybe more.  This will possibly lead to some extraordinary losses taken in the derivatives market (and derivatives gains by people who were smart enough to anticipate this absurd action.)  But then, Mr. Cox has set us up nicely for a huge crash in financials once again when the temporary short-sale ban expires in October.  October, after all, is always a great month for a market crash. 

Thursday, September 18, 2008

Fed Borrows $100 Billion From Treasury

Treasury Department announced today that it is auctioning a total of $100 billion in bills to boost the Fed's liquidity programs.  This is IN ADDITION to the $100 billion it announced yesterday (updated with correct information.)  The good news is that the Treasury is still considered a good enough credit to allow it to borrow money for free.  Yesterday's auction of $40 billion of 35-day bills had a stop-out rate near zero.  Today's two auctions of $30 billion 20-day bills and $30 billion in 76-day bills (see update below) also had stop-out rates of .10% and .25% respectively.  The bad news is that it implies that investors are hoarding treasuries and avoiding nearly every other money market instrument (see related story below on money markets.)  According to the Wall Street Journal, the US commercial paper market shrank by $52 billion in a week and rates have soared.  What are the implications of this?  Any company that has to issue CP to fund their operations may run into liquidity problems.  The Fed releases its balance sheet this afternoon which will provide an interesting insight into how much the Fed's holdings have changed in the past week.

Update:  The $30 billion in 20-day cash management bills auctioned today had a stop out rate of 0.10% and was three times oversubscribed.  Gulp! 

Wednesday, September 17, 2008

Money Markets in Complete Panic

The Fed conducted two auctions under its TSLF program today which attracted significant demand from primary dealers.  Under the TSLF, dealers offer hard-to-finance securities in return for Treasuries.  Investors are hoarding Treasuries because they are unwilling to hold any other collateral for fear that a counterparty will default leaving them with securities that they can't sell.  This hoarding has caused Treasury bills to trade close to zero, a highly unusual situation that last occurred around the time that Bear Stearns was on the brink and then not since World War II.  The TSLF is meant to alleviate this problem by helping dealers to finance their less desirable securities and giving them treasuries in return.  The results of the TSLF, which generated record demand at record spreads was an indication of how desperate dealers are to secure funding  The 28-day auction drew $71.25 billion in bids versus the $35 billion offered by the Fed with a stop-out was 3.00% (quoted as a spread).  The 14-day auction drew $64.35 billion versus the $35 billion offered with a stop-out of 2.50%.    
If you are looking for an explanation as to why Morgan Stanley and Goldman Sachs' stocks were getting pummeled the last few days despite their relatively decent earnings results, this is it.  Although the SEC and some pension fund managers believe this is an attack on the US financial system by opportunistic hedge funds, I believe it is investors reacting to the potentially catastrophic consequences of a complete seizure in the money markets that is bigger than the Fed's capability to resolve.  Morgan and Goldman rely on the money markets for financing, which are still digesting the consequences of the rash of bailouts, takeovers, and  bankruptcies.  Two money market funds just reported that they broke the buck due to investments in Lehman commercial paper.  How willing will money market funds be to invest in any more broker dealer investments? 
Calculated Risk highlights a quote from Morgan CEO John Mack in a NY Times article that is terrifying.  According to two people briefed on talks between John Mack and Citi CEO Vikram Pandit, Mr. Mack said "We need a merger partner or we're not going to make it."  It has been confirmed in the mainstream press that Mr. Mack is seeking a buyer for Morgan Stanley, however, that quote has a sense of urgency that is very unsettling.  If Morgan strikes a deal, can Goldman survive as an independent dealer or will it too be forced to find a partner?  I honestly don't know, and I suspect that the market's trajectory will continue downward until these issues are resolved.  

Chris Cox Bans Short-Selling Again, Market Goes Lower Anyway

Undeterred by the recent spate of bankruptcies and government bailouts, Chris Cox once again pointed the finger at short-sellers.  "These several actions today make it crystal clear that the SEC has zero tolerance for abusive" short-selling.  One of the actions introduced today was to get rid of the market maker exemption for short-selling.  I suppose the SEC has a strong interest in reducing the efficiency that has resulted from years of competition in the options market that has tightened spreads to a penny.  Mr. Cox now wants to penalize options traders if they fail to locate stock when they short stock to hedge against customer trades.  Options market makers are just hedging their risk to execute trades for customers, not plotting against the demise of US financials.  It's sad that the head of the SEC doesn't understand how the market it is supposed to regulate actually works.  The only thing crystal clear about the SEC's actions today is that the agency has its head up its own ass.  Sorry, I always mean to keep this blog family friendly but this has really hit a nerve.  Does Chris Cox know that Lehman bond holders are not expected to recover more than around 40 cents on the dollar?  Somehow that is an indication that the short-sellers of Lehman's stock were right and that the SEC should perhaps be investigating Lehman for accounting fraud.  Ditto AIG.  Why did AIG need to borrow $85 billion in cash from the government?  Because its derivatives books was blowing up, yet the company continued to reassure investors that everything was ok because is was simply holding these derivatives to maturity and that the market was foolish for requiring them to mark to market.  Nice try, Mr. Cox, but the market is down 387 point so far today because of very serious fundamental problems that have nothing to do with naked short selling.   

The Fate of Morgan and Goldman

While Lehman's assets are getting a true mark to market in bankruptcy court and Merrill and Bank of America are busy hammering out the details of their proposed merger, investors have turned their attention to Morgan Stanley and Goldman Sachs.  Both investment banks reported positive yet much lower earnings this quarter, but questions about their future as stand-alone investment banks remain.  Why?  Because the money markets are no longer willing to support an investment banking model.  Investors have finally figured out how risky it is to borrow money short to finance a huge, risky trading operation.  Morgan Stanley and Goldman Sachs have emerged as the best risk managers on The Street, yet sentiment has now appeared to turn against them.  Despite the AIG bailout by the US government, which was a far better alternative for the investment banks than allowing a bankruptcy filing, both Morgan Stanley and Goldman Sachs' stocks are getting routed in pre-market trading.  Credit default swaps on Morgan Stanley have now spiked to levels last seen on Lehman Brothers' debt.  Remember Lehman?  That other investment bank that went bankrupt last weekend?  If you thought the turmoil was over, think again.    

Tuesday, September 16, 2008

Fed Bails Out AIG With $85 Billion Loan

Not to be outdone by Treasury Secretary Hank Paulson's Fannie and Freddie rescue operation, Bernanke stepped up to the plate to try his hand at a takeover of a failing financial institution.  AIG will receive an $85 billion two year loan from the government, who will take a 79.9% equity stake in the company.  The plan is suspiciously similar to the Treasury's promise to inject preferred equity into Fannie and Freddie in return for a 79.9% equity stake announced a little over a week ago.  Here I was hoping for something creative and unfamiliar.  But no, it's the same old government bailout plan.  If you're concerned about your tax payments financing an $85 billion loan to a highly leveraged financial firm that went from only needing $15 billion to desperately pleading for $85 billion in the span of about 3 trading days, fear not.  The taxpayers will be protected, the Fed said, because the loan is backed by the assets of AIG and its subsidiaries.  Correct me if I'm wrong but those assets seem to be underperforming.  Anyone who is amazed at how rapidly the firm kept recalculating the cash necessary to stay afloat just learned a valuable lesson in finance.  The official term used in derivatives trading circles is a "blowout."  Selling volatility seems like a nice easy way to collect premiums and produce a deceptively steady income, until you have a blowout.  That is when an extremely unlikely event causes you to lose all of your capital in one fell swoop.  If you've ever traded on an options trading floor, you'd hear this term used occasionally in the following way:

Trader #1:  Dude, where's Mack today?

Trader #2:  What, you didn't hear?  He blew out.

Trader #1:  No way! On what?

Trader #2:  Sold too many of those Lehman 15 puts at a 500 vol.  He thought they were juicy.

Trader #1  Dude, that's too bad.  I just thought you meant he ate some bad sushi.

AIG just had the mother of all derivatives blowouts.  The Fed thought the blowout was so bad that it would inevitably lead to catastrophic losses in the already battered capital markets if it let AIG fail.  Money from the private sector was not forthcoming so it was either a government bailout or a bankruptcy filing.  So, my fellow taxpayers, thanks to Hank Paulson, we're in the mortgage finance business.  But thanks to Ben Bernanke, we are now all derivatives traders.

One Fed Meeting Down, One More To Go

The Fed left the fed funds rate unchanged at 2%.  I am surprised they didn't bow to the pressure from Wall Street firms hoping to get one more cut to help ease strains in the capital markets.  The equity markets initially sold off on the news, then rallied, then sold off, then rallied to finish up on the day.  I may have missed a rally or a sell-off in there.
With one Fed meeting down, the market can now turn its attention to the other meeting taking place, the one between AIG, the Treasury, the Fed, and any banks still remaining in business.  Apparently, the Fed is considering a conservatorship as an option for AIG.  In my previous post, I joked about Morgan Stanley scratching out Fannie and Freddie's name on a memo and replacing it with AIG's name as MS had been hired as an advisor to create a resolution to the AIG debacle.  Really, I was joking.  But it appears as if this might occur.  So we got rid of moral hazard for about two days.  It's a start, I suppose.     

Money Markets in a Panic, As Turmoil Continues

The Fed injected $50 billion in liquidity into the money markets to counter a spike in the overnight repo market.  The overnight repo rate opened at 5.75% as banks scrambled to find financing from reluctant lenders.  The panic in the capital markets continues unabated.  The repo rate declined once the Fed intervened in the money markets with extra liquidity.  This injection was earlier than the Fed ordinarily conducts its daily money market operations, indicating they stand ready to act again if necessary.  The Fed's actions followed on the heels of liquidity injections by other Central Banks around the world.
I believe it is virtually a foregone conclusion that the Fed cuts the fed funds target and the discount rate today by 50 basis points.  Although this will probably weaken the dollar and is not an ideal act, it is a better option than watching another financial institution implode.  A 50 basis point cut should help the banking system by lowering financing costs, although the seizure in the money markets may continue for some time, particularly over year end.  Everyone send a thank you note to the rating agencies for helping this situation along with their extremely tardy downgrade of AIG and WaMu yesterday after the market's plunge.  

Monday, September 15, 2008

Rating Agencies Put Nail in Coffin of AIG, WaMu

What does every 5% one-day drop in the Dow really need to give it a big boost?  How about an after-hours downgrade by the rating agencies of the two financial institutions currently perched on the bankruptcy precipice.  The folks at S&P were apparently the last people in America to figure out that WaMu's credit was below-average as they finally downgraded the stock to "junk".  The downgrade of WaMu was a foregone conclusion (it's a $2 stock, for the love of God) and shouldn't have any immediate affect on the bank other than merely stating the obvious.  It was the other after-hours downgrade that further torched financial markets.  After a brutal day, during which AIG's stock was down another 51% and the company was forced to go begging for cash from the state of New York, to the Fed, to what remains of the investment banking community, AIG was slapped with the final indignity: a downgrade of its credit ratings by S&P, Moody's and Fitch.  The downgrade will force the insurer to post more collateral against its derivatives portfolio, thus creating serious liquidity problems.  It's very interesting that the ratings agencies just figured out TODAY that AIG was carrying a tad bit too much risk in its derivatives portfolio relative to its capital base.  In fact, I would label this revelation as inconvenient and extremely unproductive given that the capital markets are paralyzed with fear and are unwilling to lend to yet another financial institution trapped in a death spiral.  The Fed has asked Goldman and JPMorgan to make $70 to $75 billion in loans available to AIG.  Unnamed sources claimed they overheard the investment banks exclaim "Say What?" in response to the request.  The Fed has also hired Morgan Stanley to examine alternatives for the beleaguered insurer.  It is rumored that Morgan Stanley took the Fannie and Freddie bailout plan they recently crafted for the Treasury, scratched out their names, replaced it with AIG, and left the memo on Paulson and Bernanke's desk.  
SEC Chairman Chris Cox has been remarkably quiet during the recent turmoil.  Perhaps he has finally discovered the joys of shorting stocks that go down 99% within weeks and is reluctant to impose restrictions.  If Mr. Cox wanted to make himself useful (which is questionable), he should've put a temporary freeze on rating agency downgrades rather than going after short sellers.  The agencies are too late to do anyone any good.  They are merely inciting further panic.  Note the 6% plunge in the Nikkei and the drop in the S&P futures after hours.  Prepare yourselves for another volatile day. 

AIG Granted Access to $20 Billion in Funding

AIG will be allowed to access $20 billion of assets held by its subsidiaries to use as collateral to borrow cash to fund its day-to-day operations.  The stock has ripped $1.50 on the news, which is quite the rally considering that AIG was trading at $4.50 before the news hit the tape.  This should buy the firm a bit of breathing room to dispose of assets to meet margin calls that it is more than likely receiving from its counterparties today.  The question remains is $20 billion enough to keep the firm afloat until it can find a more long term solution to its liquidity problems?  The market is still sorting it out.
I must admit that there has been shockingly little hard news today considering what a big weekend we had.  Banks are still trying to come to grips with their exposure to Lehman, AIG, WM, insert name of blow-up du jour.  The repercussions of these major events will be felt for some time.  Watch for more "analysts" and "pundits" claiming that this is truly the bottom.  I swear if I hear even one money manger on CNBC mention this as the bottom, I'm buying more puts.

Sunday, September 14, 2008

AIG Rejects Private Equity, Potentially Committing a Fatal Error

In a bold move, AIG reportedly turned down a significant investment from private-equity because it would have meant turning over control of the company.  The insurer, facing a potential liquidity crisis if it is downgraded by the ratings agencies, is now seeking access to $40 billion in loans from the Fed until it can raise capital on friendlier terms.  Relatively new CEO Robert Willumstad doesn't appear to be keeping up with current events.  The Fed is no longer in a particularly charitable mood.  AIG's stock was down 50% and spreads on the company's credit default swaps soared last week.  S&P futures are currently down 40 points, and the entire banking system teeters on the brink of collapse as it struggles with the implications of a Lehman bankruptcy.  Although the Fed is now taking equities as collateral in the primary dealer credit facility and any investment grade debt in the Term Securities Lending Facility, it is only taking these measures to avert a complete and total meltdown in the capital markets.  It is not likely to look favorably on an insurer that had an opportunity to raise capital and chose not to because it didn't like the price.  After all, the Fed passed on a bailout guarantee for a Lehman acquirer and is allowing the investment bank to fail.  Six months ago the market rallied because it believed that the Fed's decision to grant investment banks access to the discount window implied that the Fed wouldn't let an investment bank fail.  The market won't rally tomorrow.  Spreads in the credit markets are likely to widen.  As the stock market gets pummeled, AIG's situation will only grow more grave unless the restructuring plan it will announce tomorrow is set in stone.  The market is likely to view any signs of ambiguity in the plan with the same disdain as it viewed Lehman's plans.  Mr. Market may respond with the following:  "Sure you're going to sell some assets, but you should have done that yesterday.  You should've just hit the bid because if that bid comes back, it is bound to be lower.  So what if you have access to the discount window?  So did Lehman.  They didn't make it.  Wait. What???  You turned DOWN an equity investment?  Because you didn't want to lose control of the company?  Here's a clue.  You guys aren't doing a very good job.  You're stock is in the toilet.  Your credit default swaps are indicating that you are in extreme distress.  You should've handed over the reigns.  No way those private equity guys could do a worse job!"  
Tomorrow will be a rough day in the market.  If things get too ugly the Fed might cut interest rates again, which would plant the seeds for the inflation of some other kind of bubble.  We've already been through tech and housing.  What next?  I'm betting on a mattress bubble, because that's where I'm keeping my money.   

Lehman Bankrupt, Bank of America Buying Merrill

Both Barclays and Bank of America opted out of purchasing Lehman.  No surprise.  I wouldn't have bought Lehman without a $60 billion guarantee from the Fed either.  My sources are telling me that a bankruptcy filing by Lehman is imminent.
Meanwhile, Bank of America has moved on to considering a purchase of Merrill Lynch.  Interestingly, a sale of Merrill wasn't even in the cards until this week when it became apparent that investors were losing confidence in any leveraged institution's ability to survive through the credit crunch.  No word on Washington Mutual or AIG's fate.  I guess we'll resolve those issues next weekend.     

Friday, September 12, 2008

Foreclosures, Retail Sales, and Financial Company Deathwatch

US home foreclosures rose again in August.  According to Realty Trac, one in every 416 households received a foreclosure filing in August affecting 303,879 properties nationwide, an increase of 12% from July and 27% from August 2007.  Realty Trac indicated these were the highest numbers they've seen since they started tracking foreclosures.  Nevada was once again ranked as the state with the highest foreclosure rate, followed by California and Arizona.  The rate of increases in default notices moderated in parts of the country due to measures taken by states to give troubled borrowers more time before foreclosure proceedings are initiated.  Whether extra time will actually keep borrowers from ultimately defaulting remains to be seen, but this can be viewed as a small positive in otherwise bleak news.
Meanwhile, retail sales were down .3% with ex-autos down .7%.  Excluding gasoline, however, purchases were unchanged last month.  I think this indicates that consumers are dodging those foreclosure notices from the bank by walking to the mall and shopping all day.  

A few updates on Financial Firms on Life Support in a pleasing bullet point format:


Thursday, September 11, 2008

What Price For A Lehman Takeover?

After weeks of speculation surrounding Lehman's fate, a period of time during which analysts were frantically upgrading and downgrading the stock, we are near the final chapter for the storied investment bank.  Despite all of the pundits who continued to insist that Lehman was no Bear Stearns, the final chapter of this story seems suspiciously similar.  Here we are near the end of a week filled with rumors of a liquidity crisis, during which the company posted wrenching losses and apparently drove away any potential investors with unrealistic valuation expectations, and a stock that has fallen off the precipice.  Apparently, Lehman must find a partner in a very short period of time or risk having its credit downgraded which may lead to a real liquidity crisis.  Bank of America is among the potential buyers, according to the Wall Street Journal.  If it is indeed the case that an acquirer can cobble together a bid for an investment bank with over $600 billion in assets, many of them difficult to price, in a 48 hour period, what will it be willing to pay?  It seems incomprehensible that an acquirer would offer to pay anything for Lehman's equity at all.  This is a distressed sale, into a market that is already suffering from significant capital constraints.  As I've stated many times before, very few financial institutions are in a position to digest a firm of Lehman's size.  Clearly, nobody wanted to buy Lehman at full price, so if a sale happens at all, it will be at a discount.  But as with the JP/Bear deal, shareholder approval is required.  If the acquirer offers nothing for the equity, then the shareholders can threaten to vote it down and the market will once again face the prospect of a counterparty's failure.  The Treasury and the Fed are involved in orchestrating this shot-gun marriage as this time the Fed is also a counterparty to Lehman.  Although Lehman has yet to borrow from the discount window, it has more than likely borrowed through the TSLF, and the TAF, the Fed's other loan facilities that it offers to dealers.  These loans are collateralized with assets that are difficult to finance.  If Lehman fails, the Fed is stuck with assets it has to liquidate at uncertain prices.  Rather than face the distasteful prospect of having to testify to congress and explain why the Fed owns even more illiquid mortgage assets, Bernanke and Paulson would much rather stuff someone else with all of Lehman's risk.  Why the market rallied so powerfully into the close remains a mystery to me.  How the now inevitable demise of what used to be the fourth largest US investment bank is rabidly bullish news is really beyond my comprehension.  Post-close financials are sharply lower, particularly Lehman, which is down another 25%.  I suspect the rally won't last.  But, as always, the market is full of surprises.

Drugs and Lots of "Drilling" Discovered at Government Agency

An Interior Department investigation of the Minerals Management Service's royalty collection office in Denver found evidence of significant corruption by employees of the organization.  If you've never heard of the MMS, it is a government agency that is supposed to issue offshore drilling leases and collect royalties from the oil industry.  However, it seems as if the employees of MMS were engaged in activities related to drilling, but not of the offshore variety.  Apparently, the Interior's inspector general found that workers at the MMS in the Denver office were partying, having sex, using drugs and accepting gifts and ski trips and golf outings from energy company representatives with whom they did government business.  The investigations exposed a "culture of ethical failure."  Between 2002 and 2006, 19 oil marketers, nearly a third of the Denver office staff, received gifts and gratuities from oil and gas companies, including Chevron, Shell, and Hess.  "Employees frequently consumed alcohol at industry functions, had used cocaine and marijuana and had sexual relationships with oil and natural gas company representatives" who referred to some of the government workers as the "MMS Chicks."  Congress was absolutely shocked at the discovery of all of this corruption and blamed it on the evil oil industry.  Because the thought of a bunch of government employees taking bribes and partying like rock stars because they're bored, underpaid, and are ethically challenged sounds completely implausible.  Democratic Congressmen pounced on the opportunity to be outraged and called for a suspension of the program.  Perhaps a more prudent solution is available, particularly at a time when the government needs every penny it can collect from anywhere.  Perhaps the MMS should just stop taking resumes from former employees of Hooters.

Market Tumbles on Pervasive Fears of Financial Failures

Lehman is trading at $4 in the pre-market.  To answer myself from Tuesday's "Will Lehman Go To Zero? Today?" post: Yes, but apparently not until tomorrow.  Equity investors have given the firm up for dead as it has finally dawned on them that the investment bank cannot recover from this crisis of confidence.  Frankly, this is terrible news for the other investment banks as the business model is seriously being questioned.  One investment bank's failure can be viewed as a "one-off" capitulation event.  Another bank clinging to survival a mere six months later begs the question of whether investors want to bet on a model that relies on borrowing huge sums of money on a short term basis.
The market is also betting that Washington Mutual is toast, as the stock has fallen below $2.  Although this is not a surprise to anyone who knew of WaMu's option ARM portfolio (i.e. anyone reading Mock The Market for the past six months) and default rates hitting option ARMs, realization has finally dawned on the market like a ton of bricks in the past week.  What is a surprise to me, is that Wachovia is yet to hit the single digits, as its option ARM portfolio is over $120 billion.
Finally, AIG has been pummeled for the past few days on widening spreads in the CDS market.  As I mentioned in my last post about AIG's toxicity after its earnings announcement, "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."  $441 billion in notional CDS?  $57.8 billion tied to subprime?  AIG is short volatility in the volatility perfect storm.  Furthermore, there is a story in the Financial Times addressing the losses that insurers are likely to suffer from the default on Fannie and Freddie CDS.  Apparently the recovery value is currently expected to be around 95 cents on the dollar on an estimated $200-$500 billion of outstanding contracts.  This translates into potential losses of $10-$25 billion for the insurance industry that offered credit insurance.  The International Swaps and Derivatives Association is expected to announce today which of the bond issues from Fannie and Freddie will be eligible to be used to settle the CDS.
Where do we go from here?  Who's next to fail?  How many more bailouts can the US grant? These are all the questions floating around in the market, which makes me think that we can only go lower from here.  

Wednesday, September 10, 2008

Lehman Posts Loss, Unveils Plan

Lehman posted a preliminary loss of $3.9 billion for the third quarter, much wider than the most pessimistic analyst estimates, and unveiled a restructuring plan in an effort to instill confidence in the wake of yesterday's 45% plunge in the stock.  The meat of the plan is to spin-off its commercial real estate assets to its shareholders and sell a stake in its prized asset-management unit.  The spin-off of the commercial real estate portfolio into a new company called Real Estate Investments Global accomplishes the task of stuffing shareholders with assets that they were hoping the bank would dump, but cushioning the investment bank from further losses in the portfolio.  Note to loyal shareholders: "Thanks! And you're wearing it!"  In the statement Lehman claims that REI Global's "primary focus would be to maximize shareholder returns by selling assets or holding them to maturity."  In my opinion, this is a fancy way to get around the indignity of having to mark these securities to market.  Furthermore, if anyone actually wanted these assets at the valuation that Lehman placed on them, Lehman would've gladly sold them and taken cold hard cash in return.
The investment bank is selling a 55% stake in a subset of its investment management division including asset management, private equity and wealth management.  It is in advanced discussions with a number of potential partners and will announce details of the transaction in "due course."  The asset management sale will be completed in an auction.  Given the recent performance of Lehman's stock price and the absence of alternatives to raise capital for the firm, I would bet that the potential bidders may be shaving a few bucks off of their bids.
In any event, the suspense is over.  Lehman has announced its plans, and investors have reacted with muted interest.  Although the stock has regained what it initially lost in pre-market trading, it is barely up after the precipitous plunge in the shares yesterday.  Continued declines in the stock show a lack of confidence and will be terrible for financials on the heels of yesterday's losses.  Prepare yourselves for yet another bumpy ride.

Tuesday, September 9, 2008

Will Lehman Go To Zero? Today?

Lehman's stock continues its death spiral, down 35% at the moment on little concrete news.  Sure KDB has walked away from the negotiating table, but did people actually believe that this deal was going to happen?  Furthermore, despite all of the rumors bandied about of potential buyers interested in a "hostile takeover," the market is now acting as if KDB was the only viable candidate in the running.  I am inclined to think that something else is behind the stock's free fall.  I am hearing a rumor that the company may pre-announce earnings today and that the news won't be pretty (no surprise to anyone with a pulse.)  I have also heard some speculation that Mr. Paulson's refusal to bailout the preferred investors in Fannie and Freddie was a large hint that the man had reached his limits in terms of offering help to ailing financial institutions.  This is a more plausible explanation for the panic in the stock.  The Fed has given them financing for MBS, the discount window, and term money market funds.  Enough is enough.  If you didn't raise enough capital when you had the chance, don't come crying to the Treasury.  Whatever bargaining chips Mr. Fuld thought he had at the negotiating table grow more threadbare with every downtick in the stock price.  Options volatility and CDS spreads have spiked to crisis levels.  If Mr. Fuld really does have something left up his sleeve, now would be the appropriate time to bust it out.           

Bailouts, CDS Defaults, and DeJa Vu

The historic bailout of Fannie and Freddie by the US Treasury turned out to be only one story in a very interesting and volatile trading day yesterday.  The repercussions of the Treasury's action will be weighed for some time, however, the tightening of mortgage bond spreads seems to be the most positive immediate benefit of the plan.  Spreads on agency MBS came in around 40 basis points, giving the entire banking sector a nice mark-to-market gain.  Interestingly, this was a huge boost to Paulson's equity investment in Fannie and Freddie, as the two firms hold enormous mortgage portfolios.  It appears as if Mr. Paulson learned a thing or two about front-running a trade from his time at Goldman.  The tightening of mortgage spreads, however, did not filter out into the rest of the bond market, indicating that the credit markets are still nervous.
Falling in the category of significant unintended consequences of the bailout was the event of default triggered in the CDS market by the conservatorship.  The ISDA will settle the CDS through cash auctions that will likely take 30 days.  It should prove to be nothing more than a back-office nightmare, unless, of course, somebody finds a huge out-trade.  Apparently the CDS market has grown exponentially, despite the fact that the settlement process is performed through the use of fax machines rather than electronic confirms.  I predict at least a few cases of "No no no!  We definitely sold these.  We were not buyers!  I don't care what your stupid confirm says.  Look it doesn't matter that I can't actually find and produce my confirm, my trader says it was a sell and there is no way I'm going to tell him that I can't find the confirm!"

In bizarre and completely unrelated news, UAL declared bankruptcy in 2002.  Unfortunately, the story was so compelling that it was posted as a new headline yesterday and picked up by Bloomberg.  I suppose it seemed so probable that UAL could file for bankruptcy again, that investors didn't even bother to actually read the story before dumping the stock.  UAL adamantly denied the filing and the error was eventually discovered.  For savvy traders who were paying attention, there was a small window of opportunity to buy UAL at $3 before trading was halted.  
The Lehman saga continues unabated.  Reports this morning about KDB officially ending talks about taking a significant stake in the firm are crushing the stock.  Lehman's options for a private sector rescue continue to narrow, which means its days are numbered.  Something tells me that by the end of the week the enthusiasm surrounding the bailout of Fannie and Freddie will be a distant memory.

Monday, September 8, 2008

Management Shake-Ups at Lehman and WaMu Can't Change Stinky Investments

If ever there was a time to slip some management changes in below the radar, this weekend was it.  While every investor worth his salt was furiously calculating a new price target on Fannie and Freddie's common and preferred, it was easy to overlook the ousting of a few key executives.  Washington Mutual gave its CEO Kerry Killinger the boot.  According to the Bloomberg report he was ousted "after he failed to halt losses tied to home mortgages."  The newly appointed CEO Alan Fishman, formerly of Meridian Capital, will take a shot next to see if he can halt the losses.  The stock initially ripped on the announcement, before investors realized that a new CEO can't change the fact that the company's balance sheet reeks like a pile of stinking dung.  Speaking of balance sheets that reek, Lehman has shuffled its management yet again.  The company is replacing the current head of fixed income (who spent all of seven months at the post) with two other guys I've never heard of (feel free to click on the link if you actually care about names.)  Dick Fuld remains in charge, and will continue attempting to concoct some sort of spin-off, recap, asset-sale, financing, write-down, half-caff with a twist, but with new yes men by his side.  In my last post about Lehman, I went out on a limb and offered to eat my crox if a deal with KDB actually materialized.  I have yet to put my bib on, so it's looking good for me.  The only good news I can find in the headlines for Lehman and WaMu investors is that Hank Paulson is finished with his Fannie and Freddie plan.  That means he can move on to the next bailout package.  

Sunday, September 7, 2008

Overseas Markets Rejoice in US Government Bailout of GSEs

Hank Paulson's plan to seize Fannie and Freddie is being greeted by cheers from overseas markets, with stocks soaring and financials performing particularly well.  It is no surprise that overseas markets like this plan.  For one thing, central bankers around the world are breathing a big sigh of relief.  After all, foreign central banks were big buyers of agency debt and were probably sweating bullets at the recent significant widening of spreads on agency debt on the panic over Fannie and Freddie's solvency.  Now that Mr. Paulson has laid out his plan which protects holders of Fannie and Freddie's debt by injecting capital if and when equity ever turns negative, central bankers don't have to worry about any embarrassing phone conversations with bosses where they have to explain how they lost the country's reserves on "speculative" investing.
Meanwhile, futures on the Dow and S&P are pointing to a sharply higher open in the US as well.  Treasuries are selling off as the "flight to quality" trade is no longer as compelling.  Given that the government will now be buying MBS outright in the market as part of Mr. Paulson's plan, it is logical that MBS spreads should narrow significantly in anticipation of the government's purchases.  However, this is one part of the plan that was somewhat ambiguous.  The plan did not specify how much MBS the government planned to buy, only that it wanted to lower mortgage rates for borrowers seeking new mortgages.  If the government is serious about affecting the spread then it will more than likely need to buy large quantities of mortgages.  A few weeks ago, I jokingly suggested that the Fed should buy agency debt to take advantage of the juicy spread between agency debt and where the Treasury borrows money.  The Treasury will basically be doing this when it begins buying MBS, holding the securities to maturity and managing the portfolio.  Part three of Mr. Paulson's plan is to turn the US government's balance sheet into an MBS hedge fund.  But I have to admit, if I could borrow unlimited amounts of money at 3.80% for ten years, I'd be looking for all sorts of high yielding assets to purchase and "hold-to-maturity."
In any event, it looks like the market will rally, at least in the short term.  This will be the big capitulation event that everyone was looking for.  No matter that Bear Stearns was the "big capitulation" event a mere six months ago and a huge failure of that magnitude was sure to mark the end of the credit crisis.  Here we sit now with two much larger failures (and several smaller ones in between), involving government guarantees yet again.  This bailout doesn't really change the deteriorating fundamentals of the housing market, it merely helps restore a modicum of liquidity to the mortgage finance market.  Yet another emergency plan was cobbled together in a rush to avoid a market meltdown, along with the Bear bailout, and all of the Fed's fancy new liquidity facilities for Wall Street banks.  We'll see how long the euphoria lasts this time.    

Fannie and Freddie in Conservatorship

Hank Paulson outlined his plan to "rescue" financial markets and put Fannie and Freddie's shareholders' out of their misery. You can read the full text of his statement here. The Federal Housing Finance Agency (FHFA) has been appointed the Conservator of Fannie and Freddie. The companies will continue to function without interruption and will pay their obligations, although senior management will be ousted. The stocks will continue to trade but the powers of the stockholders will be terminated. The Treasury has entered into a Senior Preferred Stock Purchase Agreement with each GSE. Under the agreement, the Treasury will inject capital into the GSEs at any time that the FHFA determines that assets exceed liabilities according to GAAP and will inject capital in an amount equal to the difference between assets and liabilities. The agreements are indefinite in duration and have a capacity of $100 billion with each GSE and will be senior to both the common and preferred shareholders. In return for taxpayer's generosity, the Treasury will immediately receive $1 billion of senior preferred stock in the GSEs with warrants for the purchase of common stock representing 79.9% of the common stock. The new senior preferred will accrue dividends at 10% and come with a host of covenants. The covenants of most interest to current common and preferred shareholders probably pertain to the elimination of BOTH common and preferred dividends and a limit on an increase in the GSEs' debt to 110% of their debt as of June 30th 2008. This will no doubt hurt many banks that invested in the preferred stock under the assumption that the dividends were secure. Regulators are encouraging banks to contact the FDIC if their regulatory capital levels are greatly diminished due to this action. Apparently, the Fed, FDIC and OTS are going to "work" with the institutions to restore capital adequacy.
In addition to the preferred stock purchase agreement, the Treasury will also purchase MBS outright, as well as provide additional funding through collateralized loans. Interestingly, these loans will also be available to the Federal Home Loan Banks. I suppose Mr. Paulson wanted to nip any speculation about a liquidity crisis at the FHLB in the bud. So, in effect, he is killing three birds with one stone.
Mr. Paulson's plan appears comprehensive and intends to finally put an end to all of the speculation about the failures of Fannie and Freddie leading to an outright collapse of the financial markets. Will it work? That is the $5 Trillion question. More thoughts and comments to follow, but now I have to catch my flight home.

Thursday, September 4, 2008

On Vacation

Mock the Market is taking a quick two-day vacation.  Keep in mind that the last time I took two days off Bear Stearns went bust, so exciting things are bound to happen while I am gone.  The mocking will return on Monday, September 8th.  Everyone have a great weekend.

Wednesday, September 3, 2008

Auto Sales, Beige Books and More...

US automakers reported continued declines in sales for the 10th straight month.  August sales dropped 20% for GM, 27% for Ford and a whopping 34% for Chrysler.  GM's results were actually better than expected due to heavy discounting offered yet again to entice potential buyers onto dealers' lots.  I've seen those happy GM employees on television eagerly announcing that GM's employee discount is now available to us all.  I have to give them credit.  None of GM's employees seem bitter about sharing the one and only advantage they derive from living in Detroit and slaving away for a near-bankrupt company.  In any event, the tactic managed to keep GM's numbers from being much worse, like Chrysler's, for example.
In slightly related news, GMAC, the auto and mortgage finance company still partly owned by GM, has announced that it planned to eliminate 5,000 jobs at its Residential Capital mortgage unit and close all 200 GMAC Mortgage retail offices.  The job cuts amount to roughly 60% of its workforce in addition to the closure of all of its retail offices.  It makes me wonder what exactly is left of this business, other than 3,800 employees who no doubt expect their own heads to roll soon.  ResCap claims it will continue offering mortgages directly "where there is a secondary market to sell the loans," assuming they can find that elusive secondary mortgage market.  
Clearly the $60 billion refinancing package crammed down the throats of ResCap's bond investors in June only offered a temporary respite from ResCap's mounting problems.  It was the financial equivalent of a little kid sticking his finger in the dike and hoping for the best.  Only the kid in this case was the private equity firm Cerberus.  And they have several fingers in many dikes, as they also own Chrysler.  Did I mention that Chrysler's sales were down 34% in August?
If you prefer your news to be more macro in style, the Fed released its Beige Book report this afternoon.  The Beige Book gave a rather bleak picture of the economy.  Business across most of the US was "slow," while all districts reported pressure to raise prices because of higher commodity costs.  Certainly commodity prices have dropped significantly in the past couple of weeks, which should alleviate some of those pressures.  But "slow" is never good, particularly when the Fed has little, if any, ammunition it can summon to counteract further declines in economic growth.

Ospraie Fund Closing and Other Bullish Lehman News

Ospraie Management, a US hedge fund specializing in commodities investments is closing its doors after punting 38.6% of investors' capital year-to-date.  It seems investors want their money back and the fund has opted to suspend redemptions and conduct an orderly liquidation.  How is this hedge fund's performance related to Lehman?  Back in 2005, in the middle of the great debt-fueled bull market for all assets, Lehman bought a 20% stake in the hedge fund.  I'm sure that hedge fund stake has surged in value since then.  
Moving on to other enlightening stories of how Lehman wisely chose to invest its capital during the boom, the WSJ has a story about Lehman's financing of SunCal, a developer that buys land, prepares it for houses and sells it to homebuilders.  Actually, I'm sure SunCal used to develop that land and sell to it homebuilders, but now it just holds a bunch of vacant land in Southern California.  In any event, Lehman has $2.2 billion in exposure to SunCal, which it has written down to $1.6 billion.  Lehman claims that much of the holdings are along the Pacific Coast where values have held up.  Values always hold up nicely until someone with significant bills tries to dump a bunch of land into a market where there are few buyers.  The SunCal investment is not a new revelation.  I wondered if the bank had taken enough of a markdown on this investment (as well as the Archstone REIT) given the pummeling in land values in SoCal on June 16th, after Lehman's earnings announcement.  I suppose the Wall Street Journal felt a civic duty to point out to the Koreans exactly what they were considering investing in. 
Despite all of the negative headlines, reports persist that multiple buyers are dying to buy the beleaguered investment bank.  Consortiums of Korean Banks, HSBC, the Korean Military Fund, you name it.  They all want a piece and are willing to pay a premium to book value!  I'll believe it when I see it.  If and when it happens, I will eat my crox.       

Tuesday, September 2, 2008

Speculation on a Really Slow News Day

Labor Day is over.  Financial market participants are back from vacation.  The action is supposed to heat up, with exciting news and announcements ending the summer market doldrums.  Instead we get groundbreaking new stories such as this one from the Associated Press entitled "Merrill slides against mostly rising market."  Don't bother clicking on the link, I'll summarize:  Merrill's stock is down today while other brokerage stocks are higher.  The reporter called Merrill for a comment and no spokesman was available.  Had a spokesman been available they may have had the following to say: "Um, hmmm, that's odd.  Hold please...We just fired our fundamental analyst last week for not forecasting that we'd lose $40 billion dollars this year so no comment from him, but our technical analyst says our stock was clearly overbought last week."  
If the Merrill news was not hard enough news for you, there was yet another report on KDP's continued interest in taking a stake in Lehman Brothers.  The new version of the story is that KDP is rounding up a consortium of Korean Banks to possibly buy Lehman.  The Korean market liked that news so much that it promptly plummeted 4% yesterday.  No sources were cited in the story, which firmly puts it in the category of "rampant speculation."  At this point, I wouldn't be surprised at all if insiders at Lehman were donning their best fake Korean accents and calling up reporters to keep the story alive.  Drastic measures are necessary to keep the market focused on the idea that somebody wants to buy something that Lehman has to sell.  Otherwise, Lehman has to come up with a new hare-brained scheme involving good banks and bad banks and crazy spin-off recaps with financing included to report in conjunction with the large losses it will surely report this quarter.  The good news is, the truth will be revealed in a few short weeks when Lehman reports earnings.  Speculation in the meantime is sure to continue.  

Hurricane Gustav Bludgeons Oil Prices, Spares People

In a great twist of irony, Hurricane Gustav did more for lowering the nation's gas bills than any of our congressmen could muster.  Forget about "evil speculators."  Who knew that the price of oil would surely fall if a tropical storm billed as the next Katrina turned out to be enormously overrated?  The price of oil is down over $7 on the news that Gustav did not do any major damage to the energy infrastructure in the Gulf.  I have yet to read reports of any human casualties, although have heard reports of significant property damage and that parts of the region will be without electricity for days.  Although certainly difficult for the residents of the Gulf Coast region and investors who were long oil futures, the nation just breathed a collective sigh of relief.  We all know who to thank the next time we fill up our gas tank.