Friday, February 27, 2009

Equity Futures Off on Lousy GDP, Fannie, Citi News

The US economy shrank 6.2% in the fourth quarter, confirming that we are indeed in a deep pickle.  The number was revised down a whopping 2.4% from initial estimates, nearly five times as large as the average revision.  Consumer spending dropped at a 4.3% annual rate last quarter as many lost their jobs and their lunch when looking at their 401K returns.

Citigroup finally came to an agreement with the government on the third and hopefully (but not likely) final version of its bailout package.  The Treasury Department agreed to convert as much as $25 billion of preferred shares into common stock giving the government a 36% stake, as long as private holders agree to the same terms.  The swap has been anticipated for nearly a week, so this isn't necessarily shocking news.  I suppose what has investors whacking the stock down nearly 50% before the open is that Citi boosted its loss for 2008 by 48% to $27.7 billion.  From the taxpayers perspective, the swap, is obviously a much worse deal, but at this point, we're already in bed with Vikram so, we might as well close our eyes and pretend its Brad Pitt (or Angelina, whichever you prefer).

Fannie reported a $25.2 billion loss for the fourth-quarter, and politely put in its request for $15.2 billion from the Treasury.  The benefits of conservatorship, I suppose, is that you don't have to go with your tail between your legs to Congress to plead for the money like the car company CEOs.  The most troubling portion of Fannie's announcement was the part about total delinquent loans nearly doubling last quarter to $119.2 billion from $63.6 billion in the third quarter.  Or maybe it was the statement from the company that said "We expect market conditions that contributed to our net loss for each quarter of 2008 to continue and possibly worsen in 2009."  Less than reassuring, and also an indication that Fannie will most certainly be back for more government injections to support its declining net worth.  I must have already exhausted all of the Fannie spanking pun possibilities out there.  If anyone has any new ones for me, please feel from to comment.

Thursday, February 26, 2009

FDIC Blows Through $16 Billion of the Insurance Fund in Fourth Quarter

The FDIC released its eagerly anticipated quarterly report detailing the sad state of affairs that our banks find themselves in.  At this point, investors are immune to shockingly bad news, so from that perspective, the report was well received as the Dow only sold off around 88 points.  A few highlights for those not interested in reading the press release:

  • Commercial and savings institutions insured by the FDIC reported a net loss of $26.2 billion in the fourth quarter of 2008.
  • More than two-thirds of all institutions were profitable in the fourth quarter, but their earnings were outweighed by poor performance from a few large banks.  Ahem, you know who you are.
  • Total deposits increased by $307.9 billion or 3.5%, the largest percentage increase in 10 years.  This is actually somewhat positive.  It seems that despite all the bad news, we haven't lost confidence in our banks.  It does indicate cash hoarding and risk aversion, but is still better than massive withdrawals and purchases of gold and guns.
  • Twelve institutions failed during the fourth quarter and one received assistance.  During the year, a total of 25 insured institutions failed.  The problem list grew from 171 to 252, with total assets increasing from $115.6 billion to $159 billion.
  • The Temporary Liquidity Guarantee Program raked in $3.4 billion in fees since its October inception.  Of course we can easily blow through this if any of the $225 billion in outstanding FDIC-guaranteed debt defaults or any of the banks that purchased guarantees on the $680 billion in additional deposits fails.
  • Most troubling, in my opinion, is that the FDIC blew through $16 billion of its insurance fund and only has $19 billion available.  $22 billion has been set aside for estimated losses on failures anticipated in 2009.  Call me crazy, but this doesn't seem like nearly enough to cover the potential failures.    There are 252 banks on the list with assets of $159 billion and we're just getting warmed up.  We're not even out of February and already 14 banks have failed this year compared to twelve institutions in the fourth quarter which cost the FDIC $16 billion.  The rate of bank failures is just beginning to pick up steam as the economy has hit a brick wall and default rates will continue to ratchet higher.  Next year will be far more expensive than this year so how is $22 billion supposed to cover the rest of the year?  That number seems completely unrealistic to me.  Although the FDIC board is meeting tomorrow to set deposit insurance rates and to consider adopting enhancements to the risk-based premium system (uh, ya think?), something tells me that they are completely mispricing the cost of the insurance.  Mark my words, before the end of the year, the FDIC will be hitting up the Treasury for cash.  

Headline Financial News 2/26/2009

Much to discuss today:
Despite all the gloom and doom in the headlines, futures are actually higher.  Go figure.   

Wednesday, February 25, 2009

Ambac Loses Another $2 Billion

Remember when everyone was panicked about the bond insurers going out of business?  How that was going to tank our economy?  Seems so long ago.  After so many bank failures and bailouts, the bond insurers are now contented to muddle around in obscurity as $1 and $4 stocks.  Of course, this hasn't stopped them from living out their destiny of bleeding cash as far as the eye can see.  Ambac just posted a $2.3 billion quarterly loss, which is positively bullish compared to the prior-year net loss of $3.27 billion.  The results include $594 million in realized and unrealized derivatives losses and $916 million in financial-guarantee losses largely related to second-lien and other residential MBS.  Revenue was negative $202 million compared to negative $4.79 billion, which admittedly is an enormous improvement.  However, shareholder's equity is now a negative $3.8 billion.  If you'd like to travel back in the Mock the Market time machine for a good laugh, check out my April 23, 2008 post entitled "Ambac CEO Claims "Worst May Be Behind Us."  Actually, you don't even have to read the post, the title says it all.       

Tuesday, February 24, 2009

Case-Shiller Index Signals Continued Declines in Housing Prices

Home prices in 20 US cities declined 18.5% year over year, according to the S&P/Case Shiller index.  The reading was worse than anticipated by economists, although probably not terribly surprising to anyone that reads the news.  Surging foreclosures, rising inventories, and an extremely tight market for financing only puts more pressure on home prices.  Calculated Risk has its usual array of nifty graphs if you like your bleak economic data served up in pictures.

The Wall Street Journal has an interesting article today about the difficulty that many potential homebuyers face in parts of the country where home prices are still above the conforming loan limit.  Many jumbo lenders have fled the business as there is no longer any secondary market for jumbo loans.  Basically, if you originate it, you're wearing it.  The article, although filled with mostly anecdotal stories about high income earners who are being forced to put in excess of 25% down to qualify for mortgage rates that are significantly higher than conforming loan rates, points to the inevitability of further home price declines in high priced areas.  The few remaining jumbo lenders are squeezing all sorts of fees out of potential borrowers.  The article gave ING as an example of one of the few lenders that is increasing its jumbo mortgage foot print.  ING is offering only 7 year jumbo arms at 5.5% (no 30-year fixed), with minimum 30% down for houses and 45% for condos.  Another lender is offering a 7% rate for a 30-year fixed jumbo mortgage with a 5% upfront fee.  Sounds sort of like predatory lending for rich people.  But that's what happens when you're the only guy in town offering financing.  It's called a monopoly.  The potential pool of buyers in high priced areas has shriveled from those who could put 5% down and qualify for a interest only or option arm to those who need 25% down and qualify for a fully amortizing mortgage.  This is a very significant adjustment in the demand side of the housing equation and explains why home sales in places like New York City and San Francisco have fallen off a cliff since Lehman's bankruptcy.  It does not point to a very pretty picture for home prices in those areas.       

When will housing bottom?  The answer is fairly simple.  I firmly believe that in some parts of the country prices have reached a bottomed.  There are several locations in Southern California and Northern California where prices have plummeted and foreclosure sales are brisk.  If investors can buy a property, rent it out, and receive a reasonable return, then prices have bottomed.  As for the rest of the country, until prices reach levels where homes are affordable for the median family income in that region, we're likely to see more declines.  No amount of meddling by the government is going to stop that.   

Monday, February 23, 2009

AIG: When $150 Billion isn't Enough

A few weeks ago, I read an amusing opinion piece in the Wall Street Journal that pointed to AIG as a fine example of why the government shouldn't be trusted to run our financial institutions.  The piece came to the somewhat comical conclusion that the government's intrusion into business decisions had ruined AIG's chances of ever becoming a thriving business concern.  The writer somehow glossed over the part about AIG's near certain death were it not for an initial $85 billion loan from the Fed, followed by other government guarantees that eventually totaled $150 billion.

With every ensuing earnings report, the news from AIG has gotten worse and worse.  First it was just the $400 billion in credit default swaps that were bleeding cash.  Next it was the abomination called the securities lending business, which blew a very simple and profitable business model by borrowing short and investing in long-dated illiquid ABS and MBS.  CNBC reported earlier today that the beleaguered insurance company is set to report a $60 billion loss next Monday.  Now this, I want to hear.  Because $60 billion in losses in one quarter on top of all the other losses is, I don't know, LARGE.  Unprecedented.  Absurd.  Ridiculous.  Feel free to insert other appropriate adjectives at your leisure.  CNBC's David Faber who reported the news mentioned something about commercial real estate losses, but I want details.  

The market initially did not respond to the news, which I found somewhat surprising, and then it took a tumble once the news sunk in.  The loss is huge and has implications for other financial firms.  First of all, many banks and insurance companies have significant exposure to the commercial real estate market, so an explanation of the breakdown in losses will be beneficial for evaluating other firms' exposure.  Second, if AIG is preparing a bankruptcy filing, as David Faber reports, the rush to increase margin requirements from its counterparties, one of which is Goldman Sachs, may reignite panic in the credit markets.  Many conspiracy theorists believe that Paulson chose to save AIG and let Lehman fail because Goldman would've suffered due to its exposure to AIG through its CDS positions.  Frankly, this seems like a fairly reasonable explanation for Paulson's choice, unless you'd just like to think that he was throwing darts at a dartboard.  In any case, I'm surprised that the insurers weren't pummeled on the news, and that most of the banks held on to their meager gains.

So here we are again.  Citi near another deal with the government.  AIG near another deal with the government.  GM and Chrysler near another deal with the government.  Is it a wonder that the market has made new lows and is trading at levels it hasn't seen since 1997?  

Citi and Car Makers in the Headlines, Again

So many big problems, so little time.  Although the banking sector is supposedly getting a rigorous stress test, Citi seems to be running out of time and is jumping the gun.  How about bolstering its tangible common equity before the stress test by swapping the government's preferred shares into common stock equal to a 40% stake?  This is the latest rumor floating around and reported in the Financial Times and the Wall Street Journal.  The market seems to like this news, as equity futures reversed a decline last night after the Journal reported the "talks."  Really, I have a better idea though.  What if the government just forked over an additional $10 billion (because really, what's another $10 billion at this point?) and bought 100% of Citigroup?  After all, this is the current market cap of the bank.  So really, why settle for a 40% stake?  It seems as if the administration is attempting to avoid the appearance of out-right nationalization at all cost.  Whether this strategy will work or is just an attempt to keep markets trading until the stress tests are under way on Wednesday, giving the government a little time to think of a better idea, remains to be seen.

Meanwhile, outside advisors to the US Treasury have begun lining up the largest bankruptcy loan ever to the car makers with banks and other lenders.  The financing package would amount to at least $40 billion for GM and Chrysler.  You know, "just in case."  It sort of makes you wonder why Congress didn't bring in the automakers and the bank CEOs at the same time to testify.  Then the awkward conversations before Congress could've been combined into the following snippet: 

Congressman: (to Rick Wagoner)  Why did you fly here on your private jet? You fat cat!
Wagoner:  (with head bowed) Can we borrow $40 billion?
Pandit:  We sold our jet, Mr. Congressman!  And I'm only accepting $1 in pay this year.  Did you hear that?  I'm only getting paid $1.  
Congressman:  Shut up!  You're a fat cat too!  Now since the taxpayers own you, I demand that you lend money!  Lend Lend!  Give the car companies a $40 billion loan.
Pandit:  Yes, of course, absolutely!  Whatever you say.
Congressman:  So then you will do it?
Pandit:  Yes, but there's a small matter of, um.
Congressman: Speak!
Pandit:  Can we borrow $40 billion?

See, wasn't that so much more efficient than the three days of painful testimony we were subjected to?  In any event, every option for the car makers is still on the table, even Chapter 11.  Again, the somewhat amusing part is that government officials are trying to browbeat the biggest banks, whom they accuse of not lending to consumers, aka Citi and JP Morgan, to use their capital to participate in the largest DIP financing of all time.  The government is looking at ways the Treasury could "prime" other banks making DIP loans so the government could be paid back before the private creditors.  Naturally, the banks are crying foul, while GM and Chrysler both insist they can avoid bankruptcy.  Certainly they can avoid bankruptcy, if the they can just get another $24 billion or so from the government.  But this is the last time.  No really, they mean it.  In any event, it should be understandable, given the questions of solvency of our banking and manufacturing sectors, that the market has taken it on the chin lately.  A tidy resolution to the whole mess would be welcome.  But really, that would be asking too much. 


Friday, February 20, 2009

BAC=$2.93, C=$1.80, GS=$79.40?

Apologies to my regular readers for the late posting today, but it is options expiration Friday and sometimes K10 needs to focus on trading.  There is little in the news to mock today, unless you really enjoy watching our nation's financial stocks meltdown in slow motion.  Sure it's fun making a mockery of the idiotic way in which most of the financial firms around the globe were managed during the past few years.  But even as bearish as I've been, it's quite distressing watching the market carnage and wondering if it will end before every single bank stock in America is trading in the single digits.  By that measure, we still have a ways to go as Goldman Sachs is still a $79 stock.  

As I have noted before, equity investors are confronting the serious question of whether the equity in any bank is worth more than zero.  Given the amount of leverage in the banking system and loan portfolios that are souring quickly with the deteriorating economy, it's hard to make any case to buy bank stocks.  But still, some diehards are out there paying $1.80 for Citigroup and $2.93 for Bank of America despite the fact that these stocks in particular have been in a death spiral for some time.  It is also interesting to see that investors are making, in some cases a stark distinction between Citi and Bank of America and other banks (i.e. JPM, GS, MS, none of which are at 52 week lows, much less in the single digits.)  As I learned while trading the tech bust, the market likes to correct one stock at a time as if investors come to realize slowly that all stocks in a deteriorating sector are equally screwed.  The bank stock bust seems to be following that model.

The market typically likes to rally on expiration Fridays.  That is not looking likely today.  But with both the S&P and the Dow flirting with new lows, and the prospect of an FDIC seizure or two after the close, Monday might be looking even worse.


Thursday, February 19, 2009

SEC Talking Tough, Taking Little Action

While the SEC was busy plotting and scheming to punish short sellers for single-handedly taking down the US financials, at least two major investment frauds were operating right under its regulatory nose.  Bernie Madoff had the decency to confess his sin of somehow misplacing $50 billion of his investors' life savings.  The Madoff debacle was an embarrassing scandal for the SEC, which  had investigated the firm several times over the years to no avail, after receiving a detailed outline from a whistle blower which pointed to an obvious ponzi scheme.  Mr. Madoff is under house arrest after basically handing himself over to authorities.  

In an effort to improve its public image, the SEC made a big announcement that it had unearthed a major fraud.  The problem is, once again, the major fraud had been operating for years without any action from the SEC, and would have more than likely continued to do so if it wasn't for Bernie Madoff's confession.  Nevertheless, with much fanfare, the SEC pointed its accusatory finger at Stanford Investment Bank.  Only they forgot to arrest Stanford's Chairman, Sir Allen Stanford.  The SEC has no idea of his whereabouts.  Sometimes, it's prudent to make the arrest BEFORE you issue the press release.  But for an agency that is prone to stupidity and posturing, rather than its actual mission of protecting investors, it is not the least bit surprising.

Bloomberg reports that Stanford lured clients with promises that their investments were safe.  The CDs, which are ordinarily FDIC-protected with US institutions, had no such protections for its clients.  In fact, Stanford specifically instructed its financial advisors to tell clients that the FDIC provided relatively weak protection.  Stanford told its clients that their funds would be placed mainly in easily sellable financial instruments monitored by more than 20 analysts and audited by regulators on the Caribbean nation of Antigua.  I have never been to Antigua, but I did have the pleasure of spending a year in the Cayman Islands in my youth, working for a bank to help facilitate off-balance sheet partnerships (a long, but interesting story for another time.)  I was one of three employees of the bank that worked downtown in a small three story building with perhaps 15 offices.  The three of us would go for weeks at a time without seeing any other human being enter or exit the building.  Furthermore, in the lobby of the building, the names of all of the companies that were registered to that address were listed via a bunch of spiffy plaques in a lovely display case.  I would estimate that there were over 500 companies registered at the address of the three story, 15 office building where I worked and rarely saw another human being other than the friendly FedEx guy.  This, my friends, is the hallmark of off-shore tax havens.  It's an address, period.  The odds of there being 20 analysts that monitor anything financial on the entire island of Antigua are slim to none.  Furthermore, the idea that there is a regulatory agency in Antigua that would actually monitor anything but the tides seems preposterous to me.  In any event, many people fell for it, as people have a tendency to do when an investment sounds too good to be true.  This is why we have the SEC, to prevent these types of schemes from ensnaring unwitting investors.  Too bad that our well-funded regulatory authorities in the US are about as effective as the imaginary ones on the island of Antigua.  


Wednesday, February 18, 2009

The Ponzi Report: Stanford Edition

Our crack investigators at the SEC have unveiled another mind-boggling ponzi scheme, somehow this time without the aide of a full confession from the perpetrator.  The US regulator accused Stanford International Bank, based in Antigua of an $8 billion fraud.  According to the Financial Times report, the SEC believes that Stanford falsely claimed that customers' deposits were safe and that the bank re-invested client funds primarily in "liquid" financial instruments.  It also said that the bank had falsely claimed no "direct or indirect" exposure to the Madoff ponzi scheme.  You've got to love a ponzi scheme that invests in other ponzi schemes and then denies involvement.

Naturally, the SEC was tipped off to the potential fraud by an analyst note that was critical of Stanford's claims to deliver consistent market beating returns on its $8 billion portfolio of depositors' assets.  When you have a market like this one, where every asset class is taken to the woodshed, claims of consistent market-beating returns are considered a red flag.  Any fund with a plus sign in the returns column better look out.  The SEC is on to you. 

News of Stanford's demise is sure to cause even more skepticism among investors of the safety of their financial assets.  Because if you can't put your money in a supposedly super-safe CD, where can you put it?  Perhaps this will cause a flight to quality back into money-losing hedge funds?  After all, if your fund manager was down 40% last year then he was no dumber than the average investor, and at least you know he's not using liquid paper to alter your confirms.  Then again, the mattress strategy is looking more and more appealing by the minute.  Little wonder that gold has rallied sharply in the past few weeks.   

Housing Starts Plummet

Housing Starts fell to 464,000 in January, the lowest level since the Census Bureau began tracking the number in 1959.  Single-family starts were at 347,000 and single-family permits were 335,000.  This report was significantly worse than the decline to 529,000 starts that economists were expecting.  As I've stated many time before, I know that this is an important indicator of economic growth, but given the current over-supply in housing, I don't see how we can achieve equilibrium in the market again unless unnecessary building is curtailed.  This grim reality seems to finally be sinking in to the construction sector.

In related housing news, The New York Times has a preview of the foreclosure prevention plan aimed at stemming the rising tide of foreclosures that President Obama is set to unveil today in Phoenix, a city that was the poster child of the crazy condo-flipping of yesteryear that has now turned to bust.  The proposed $50 billion plan is meant to help those homeowners who have fallen behind on their mortgage payments and are in imminent danger of losing their homes to foreclosure.  So if you are current on your mortgage, but upside-down, you are out of luck.  According to the article, the government plans to "entice banks to reduce the monthly payments of people who otherwise couldn't afford to stay in their houses," essentially splitting the losses with the banks.  Certainly this is bound to annoy anyone who purchased a home they could actually afford and have been current on their payments.  Arguably this is a bailout for the irresponsible borrower and lender, but we are way past moral hazard here.  What the administration is trying to do is reduce the number of houses that are sitting empty and putting a drag on the value of an entire neighborhoods' home value.  A bunch of vacant housing is poisonous to the economy and our administration is willing to take extreme measures to prevent a bad situation from getting much worse.  After all, builders can't spur the economy by building new homes with the current supply glut.  The question remains whether this plan in particular, after so many attempted mortgage modification plans have failed in the past year and half, will be the one that finally does the trick.  I'm not holding my breath. 


Tuesday, February 17, 2009

Market Tanks on Fears of (Fill in Blank)

US equity markets were off to a crummy start after taking a breather for President's Day weekend.  It's hard to put a finger on exactly what the new "fear" is rippling around the world.  The Wall Street Journal and Bloomberg both pin the blame in the sell-off on fresh fears about financial stocks and Western Europe's exposure to the more fragile Eastern Europe (included in a new Moody's report.)  Of course, if you hadn't factored in the probable insolvency of many financial institutions around the world into your investment plan for the year, then you probably haven't been keeping up with current events.  Then there's always more fears about the possibility of a GM bankruptcy filing which could come any minute as the US manufacturing beast is set to present its viability plan to congress again.  It is perfectly viable, just as long as it can get a couple of more bucks from the taxpayer.  

What to make of the market rout?  When will the relentless selloff end?  Since I don't know the answer, I will post a range of possibilities via a multiple choice quiz.  Feel free to play along:

a.)  When Tim Geithner is fired and Nouriel Roubini is hired as the new Treasury Secretary.
b.)  When every single bullish CNBC commentator is fired and replaced by the crazy guy I used to work with on the options floor who had been ranting about a market collapse since 1990. 
c.)  When the government throws in the towel on mortgage mods and just starts giving houses away to the poor.
d.)  When the phrase "We've put in a definitive bottom on Nov 20th" becomes the new "The problems in subprime are contained."
e.)  All of the above
f.)  None of the above
g.)  I'll be in my pimped out bunker.  Want to join me?   

Friday, February 13, 2009

Pass a Test, Get Government Money

The Obama administration appears to favor administering tests.  The plan that Geithner outlined earlier in the week to save our banking system involved a "stress test" for the largest banking institutions that would separate the wheat from the chaff.  Banks that passed the test were free to continue with business as usual.  Those that scored a C- would garner additional capital injections with stringent new terms.  Finally, those receiving an F- would be nationalized.  Bank regulators are busy investigating our country's biggest banks and the results will be revealed, hopefully soon.  The market hates uncertainty and the future of the free market remains in the hands of a few bank regulators.  Frankly, this is disconcerting news, although the market seems to have already designated which banks will fail the test.  If the bank's stock is trading in the single digits, the future is not looking particularly promising for equity and preferred shareholders.
Although the market hated Geithner's plan for testing the banks, it loved the new home loan subsidy plan leaked to the press yesterday afternoon.  Although details remain fuzzy at best, the plan involves a standardized reappraisal of homes of troubled borrowers and a test for homeowners to determine if they qualify for subsidized help from the government.  The principal on the mortgage would be written down by the lender and the government would subsidize the new mortgage payments.  When news of this new proposal hit the tape yesterday afternoon, the indexes rallied back from steep declines, as if this plan is somehow going to help save some of our insolvent banking institutions and add back those 3.5 million jobs the country has lost in the past year.  Although it may help some homeowners, it still fails to address many issues, including what to do with all of the vacant houses, the mass of REO inventory, or investor-owned properties where the investor just wishes to walk away.  I'm not even going to get into the condo overhang or impending commercial real estate defaults on deals struck at the peak of the frothy market.  

What to make of the mandatory testing by the government?  Is bank nationalization of the weakest banks really the answer?  Those that are the most bearish on the economic outlook argue for bank nationalization, while those that see glimmers of a rebound on the horizon believe it's foolish to think that the government can do a better job running our banks than the private sector.  Frankly, what concerns me about an aggressive and perhaps premature nationalization of our largest banks is the cost.  

Every Friday when the FDIC seizes insolvent banks, it announces the estimated cost of the clean-up.  I am often amazed at how high the estimated cost is relative to the size of the failed institution.  For example, on Friday Feb 6, 2009, the FDIC closed three banks, one of which was FirstBank Financial Services of McDonough, Georgia.  According to the FDIC's press release, the bank had total assets of $337 million and total liabilities of $279 million.  The FDIC found another bank to assume all of the deposits and purchase $17 million in assets.  The FDIC is stuck with the remaining assets and is estimating that it will cost the insurance fund $111 million.  The FDIC also seized Alliance Bank in Culver City, California.  The bank had assets of $1.15 billion and deposits of $951 million.  California Bank & Trust acquired all of the deposits and some assets at a discount.  This one will cost the fund $206 million, but the FDIC has a loss sharing agreement, so technically it could go higher.  The case with County Bank of Merced is similar.  County bank has $1.7 billion in assets and deposits of $1.3 billion.  The FDIC found a buyer in Westamerica Bank but also had to enter into a loss sharing agreement.  The FDIC estimates that the cost will be $135 million.

These banks are fairly small and yet the FDIC is still shelling out big bucks when they are taken over.  Particularly in the case of the banks where the FDIC could find no takers for the assets, the cost of the bailout is fairly large relative to the size of the assets.  In the case of FirstBank Financial, the cost amounts to roughly one third of the assets of the institution.  So what happens when the government nationalizes a bank with assets of $2 trillion?  Is it possible that it may cost the taxpayers $500 billion or more?  Sort of makes the stimulus package look like peanuts if we do this with more than one institution.  My guess is that this is what makes the administration hesitant about an all-out nationalization of several large banks.  Maybe if the $800 billion stimulus actually works and the economy turns, some of the institutions on the brink of insolvency today may turn the corner at some point in the future.  While hope is never a good strategy, sometimes too much preemptive meddling is not the appropriate solution either.

On a positive note, the credit markets have improved fairly dramatically in the past few weeks.  This explains why the stocks of Goldman Sachs and Morgan Stanley have rallied, while the commercial banks' stocks have stagnated.  Goldman and Morgan have sizable portfolios of fixed income assets, much like the commercial banks, without significant exposure to the consumer through pedestrian mortgage and credit card lending.  In the past few weeks, executives within these investment banking firms have come out and made bold pronouncements about wanting to pay back the TARP funds immediately because they don't need them and don't appreciate the government's attempts to tell them how to run their businesses (read: distribute bonuses.)  So why don't they just give the money back?  The answer is fairly simple:  They may not need the TARP, but they need the cheap money they garner from the FDIC's bank debt guarantees, and the special access to the Fed's fancy financing programs that didn't exist a year ago.  Give away that extra capital cushion AND lose the ability to issue government guaranteed debt equals a possible run on the bank again ala September 2008.  The risk is too great.  Plus, when you're in the business of making a spread, cheap money is a necessity.  It's much easier to talk a big game than to actually follow through.  The market has bought into the posturing, of course, because the market is susceptible to the BS that flows freely from the mouths of these "financial geniuses."  The market seems to have forgotten that these are the same geniuses that said the worst was over a year ago.     

Thursday, February 12, 2009

Economic Roundup 2/12/2009

  • Congress and the White House reached an accord on a $789.5 billion economic-recovery package.  You can read further details here, but in general nobody will pay any taxes ($282 billion in tax cuts) and we're going to spend spend spend (the balance.)
  • In related news, the Chinese hate us.  No, really.  Those who fear that China will stop purchasing our Treasuries and leave us with few options for financing to pay for our mounting deficits should relax.  Luo Ping, a director-general at the China Banking Regulatory Commission said on Wednesday that China would continue to purchase US Treasuries because it had no choice.  He also went on to say "We hate you guys.  Once you start issuing $1 trillion-$2 trillion...we know the dollar is going to depreciate, so we hate you guys, but there is nothing much we can do."  This quote is in the Financial Times article, I am not making it up, I promise.
  • Retail sales actually rose unexpectedly in January by 1%, although the previous two months were revised lower and year over year sales were down 9.7%.  
  • The number of US workers filing new claims for jobless benefits remained near quarter-century highs above 600,000.  Total jobless claims lasting more than one week hit a fresh record, near the five-million mark.  The job loss picture remains grim.

Wednesday, February 11, 2009

Credit Suisse Punts $5.2 Billion

On the heels of UBS's impressive $7 billion fourth quarter loss, Credit Suisse proved that it is truly Switzerland's second-largest bank by posting a $5.2 billion loss of its own.  The 6.02 billion franc loss was higher than the 4.2 billion-franc estimate that analysts had expected after throwing a bunch of darts at a dartboard.  The losses were due to a 3.19 billion franc writedown on leveraged loans and structured products and failed trading hedges.  Furthermore, profit at the private banking unit fell 36% due to a provision for auction-rate securities.  The bank did report an inflow of 2 billion francs of net new money from wealthy clients (perhaps those fleeing from UBS?) and have seen positive new assets in January.  Credit Suisse now anticipates higher returns from its money-management operations and lower returns from the securities units and lowered its "mid-term" goal for returns on equity to 18% from over 20%.     

Tuesday, February 10, 2009

A Couple of Commercial Real Estate Anecdotes

Here's a quick follow up to my post yesterday about two former Harry Macklowe-owned office properties in Manhattan, the Worldwide Plaza and 1540 Broadway.  Apparently the deal between Fillmore Capital Partners (the holder of the mezzanine debt on the defaulted properties) and Deutsche Bank (the former holder of the senior debt and current owner of the properties) could not reach a deal.  The contract was expected to be signed yesterday, but for some reason the parties didn't finalize the deal.  According to the article in the Wall Street Journal, Deutsche Bank has been trying to sell the properties since early 2008 when Macklowe defaulted and handed over the buildings.  The bank supposedly had bids in hand above $2 billion when NBC Universal walked away from signing a lease in the Worldwide Plaza.  To quote the Journal "That discouraged potential buyers who calculate returns on investment based on how much cash buildings generate from rent collections."  I like that.  Potential buyers in 2008 and 2009 apparently like to calculate returns based on actual cash flows from the building.  Whereas commercial real estate investors prior to the credit crunch calculated returns based on imaginary ponzi fairies that visited them in their dreams.  This sort of explains why we have a credit crisis.

Calculated Risk reports, via the Boston Globe, that the John Hancock Tower in Boston will be auctioned off March 31st.  The Hancock Tower was part of the Broadway Partners 2006-2007 leveraged buying frenzy.  Broadway paid $1.3 billion for the building in 2006 and the current value of the building is estimated at between $700 and $900 million.  Something about cash flows and rent being related to valuation...I'll have to check my notes.  In any event, anyone interested in bidding on this one, give me a call.  I've been looking to acquire a trophy property or two, but I'm a little short on the cash.  If we rub a few cents of equity together, line up the financing from Deutsche Bank, then maybe Deutsche can just shovel it into the TALF, and it's a win for everyone.  Well, almost...

Then again, maybe we don't want to bid too soon.  After all, the carnage in the commercial real estate market is really just beginning.  A friend sent along a link to a great article in DealBook yesterday about the wreckage following Sam Zell's ingenious sale of Equity Office Properties to Blackstone Group for $39 billion in 2007 (aka "the top".)  Blackstone flipped hundreds of the buildings for $27 billion to several overeager buyers.  Many of the 16 companies that bought Equity Office buildings are now stuck with significant debt while the value of the assets are plummeting as they struggle to fill empty office space.  Harry Macklowe was just the first to blow-out.  Maybe I'll wait to make a move on that trophy property purchase after all...    


Geithner Tanks the Market

You can read the full text of Tim Geithner's speech here.  A quick summary of the salient points:
  • More transparency via the new website  If you click on the link, it just says "This site is coming soon."  We're not fully operational on the transparency bit yet.
  • Banks will be required to go through a stress test where the various government agencies with authority over our nation's major banks will conduct a forward looking assessment about the risk on balance sheets.  Those institutions that need additional capital will be able to access a new funding mechanism from the Treasury as a bridge to private capital.  The capital will come with conditions to ensure that every dollar of assistance is used towards greater lending.  The assistance will also come with terms that encourage institutions to replace public assistance with private capital as soon as possible.
  • A Public-Private Investment Fund will be established.  The program will provide government capital and financing to help private capital buy crappy loans and assets from our banks.  This program is still a work in progress and the government is seeking input from market participants (i.e. they're on the line with Bill Gross.)
  • In conjunction with the Fed, the government will commit up to $1 trillion dollars to support the Consumer and Business Lending Initiative.  You can read the details of the statement from the Fed about the TALF here.  The program will be extended to include other types of newly issued AAA-rated asset-backed securities such as CMBS, private label MBS in addition to the previously announced auto loans, credit cards, student loans and SBA-guaranteed small business loans.
I suspect that the portion of Geithner's speech that has spooked the market is related to the stress tests being performed on financial institutions.  Any financial institution requiring further injections of public capital will get that capital on much harsher terms, consequently, it's fair to pummel the stocks that will require further government investments.  Certainly if the government finds that a large institution or two cannot survive, then this time perhaps equity holders and preferred equity holders may be entirely wiped out.  Furthermore, setting up a private/public bad bank isn't anywhere near as promising for a potentially insolvent institution as a bad bank that is purely government funded and a waste receptacle for unwanted assets.  If private investors were willing to purchase assets at the prices where banks have the assets marked, we wouldn't have a problem then, would we?  Even with government financing, private investors will still be looking for a bargain.  Nobody is going to raise the bid to par just because they can get 75% of the purchase financed.  In a scary market like this, with so much uncertainty in the economic outlook, is anyone with any money left going to stick out their neck?  No.  It would've been much easier to have the government buy the first trillion before throwing out a bid.  

The TALF, while a good idea in principal, doesn't really address the problem of legacy assets.  It merely creates a financing market for new securitizations.  Since underwriting standards are bound to be better this time around, I'm not terribly concerned about future losses on the TALF.  However, somebody still has to pay for the cleanup of the legacy toxic assets.  It looks as if we're not quite out of the woods yet.  

You and Us UBS, and Another $7 Billion Loss

Sure $7 billion might sound like huge loss, but let's put things in perspective, shall we?  UBS's loss actually narrowed from the fourth quarter of last year, so its fourth quarter results were actually fabulous in comparison.  The Swiss banking giant announced that it would cut another 2,000 jobs.  Total losses for the entire year amounted to 19.7 billion francs ($17 billion.)  As I noted in my prior post about Wall Street bonuses, UBS agreed to sharply reduce bonus payments as part of an agreement with Swiss regulators, doling out 1.16 billion francs compared with 7.91 billion francs in 2007.  Although the investment bankers at UBS were clearly unhappy with this meager bonus pool, it's safe to say that any company that isn't a systemic threat to the world financial system doesn't get to pay out any bonuses after losing $17 billion in a year.
The largest hit to net profit came from a 4.2 billion franc charge related to the transfer of toxic assets to a so-called bad bank managed by the Swiss National Bank.  Congratulations to the Swiss citizens who are now stuck with any further losses from UBS's ill-timed leap into the high-risk world of CDOs.  A further 2.3 billion francs came from charges including write-downs on leveraged loans.  On the bright side, assets have stopped surging out of the wealth management unit and the bank is cautiously optimistic about its prospects in 2009.  In times like these, cautious optimism seems like a huge improvement over the blatantly obvious lies that spewed from investment bank management when the worst was supposedly over last march.    

Monday, February 9, 2009

Deutsche Bank Offers Financing to Unload Remaining Macklowe Buildings

The last time we checked in with Mr. Macklowe's commercial real estate legacy, it was May 2008.  The formerly high-flying real estate developer was dumping the GM building in Manhattan to pay back his mezzanine lenders, Fortress Investment Group, so that his personal assets would remain, well, his personal assets.  The sale of the GM building as well as three other towers went off without a hitch, as the commercial real estate market had yet to come to a screeching halt.  Mr. Macklowe was not booted out of his fancy digs at the Plaza Hotel.

But what has become of the other buildings Mr. Macklowe was forced to hand over to Deutsche Bank when he defaulted on his loan?  The Wall Street Journal has a good piece on two of the properties left in Deutsche Bank's possession: the World Wide Plaza and 1540 Broadway.  A San Francisco based hedge fund, Fillmore Capital Partners, is currently in talks to take control of the two office buildings.  Fillmore owns as much as $400 million in mezzanine debt on the properties and is considering purchasing the buildings to salvage its own souring investment.  Because doubling down on a losing bet is always a savvy investment strategy.    

Deutsche Bank apparently has attempted to auction the buildings and came close to doing a $2 billion deal, but the bids evaporated as the financial crisis mounted.  Complicating the matter further, both buildings have significant empty space making it much more difficult to garner a high value on the properties when the cash flows, well, aren't flowing.  According to the article it is unclear how much additional capital Fillmore would need to contribute to do a deal, but Deutsche Bank is willing to offer financing.  The good news is if a deal does go through, then Deutsche Bank will be relieved of this albatross and Fillmore Capital will be working hard to try to salvage its original investment, if that is even possible.  The bad news for Deutsche is that if it is providing the financing, in a year or two it may be experiencing deja vu all over again.  

Friday, February 6, 2009

What to Do About Wall Street's Bonus Problem?

Populist fury over bonus payments awarded after taxpayer-funded bank bailouts has finally caused our lawmakers to wake up and take action.  Sadly, much like the curbs on mortgage lending that Congress pushed through four years too late to serve any purpose, the recent pay caps, while symbolic, fail to address the issue of misaligned compensation schemes at banks.  The reality remains that many people were paid outrageous sums to take extraordinary risks with other people's money and caused a calamity so great that the government was forced to intervene to halt a full blown collapse.  A $500,000 pay cap on future executive compensation at firms that take significant money from the government is perfectly reasonable in my view.  Critics of the plan pull out the old "but the talent will leave to go work somewhere else" card.  These institutions will be stripped of the smartest people, the thinking goes, and the government-owned institutions will wind up with all the deadbeats who won't be able to compete with all of the brilliant competition from better firms.  I'm left wondering why that's so bad.  

First of all, maybe we need the really talented people to go out and start their own firms and hire other talented people.  The economy needs new companies and new jobs.  Let the brilliant launch their own firms, with their own capital.  It's hard managing your own money and taking risk that you must personally bear.  The Wall Street Journal has a great article today that illuminates the hazards of hiring incredibly brilliant people to take tremendous risks with the firm's capital.  The article details the "fall" of Boaz Weinstein, a 35 year-old star trader, who made $1.5 billion in profits for Deusche Bank in 2006 and 2007, only to lose $1.8 billion in the fourth quarter of 2008.  For this amazing round-trip zero-sum game, accomplished by tying up billions of Deutsche Bank's precious capital, Mr. Weinstein was paid $40 million a year.  The article is filled with anecdotes about how brilliant Mr. Weinstein is, how he's a chess master, an accomplished blackjack player, etc.  I don't dispute his brilliance at all, much like I've never disputed the brilliance of any of the folks, some with Nobel prizes, who sunk Long Term Capital.  I just think he was paid far too much in the past two years for adding no value.  Mr. Weinstein has been let go from Deutsche and is starting his own hedge fund.  I wish him luck.  Maybe he can take a few of the other geniuses that helped him wipe out Deutsche Bank's prop desk.  They can go on the road, try to raise money, and make another go of it.  If he's successful, then at least there will be somewhere for all of the other talented but underpaid to go when they feel hemmed in by the $500,000 pay cap.            

Clearly, the problem with Wall Street's old business model is that it made it too easy to take significant risks, get paid gobs of cash in the short run, and then just jump ship when the losses or lawsuits hit.  The only downside was that your career might be cut short in the next downturn if you didn't survive the layoffs, but if you made millions, you were still better off financially than in any other pursuit.  Even if you crossed the line ethically, it didn't matter because typically the firm would pay a large settlement and then move on to the next money-making borderline-fraudulent activity.  It's precisely why there is a scandal roughly every 5-8 years on Wall Street.  The guys who are usually in charge when the scandal is uncovered are not the same guys who committed the acts.  So the new management can pay the fine, blame the old management, and move on.  This cycle, however, has come to a screeching halt.  Wall Street finally did something worse than pumping internet stocks, pushing crappy Enron off-balance sheet partnerships, and selling worthless Worldcom bonds.  It committed the ultimate crime:  It finally blew itself out and turned to the government for money.  

Apparently UBS is having problems with the bonus issue, according to the Wall Street Journal.  The bank eliminated cash bonuses for executive directors and managing directors of its investment bank.  The move came amid heavy pressure from the Swiss government, which lopped off one billion francs from UBS's initial proposal of three billion francs in bonus payments.  The article goes on about how this move has triggered questions about the firm's commitment to investment banking and that there are concerns that top bankers will flee.  One of the heads of investment banking expressed frustration and claimed that top executives needed to convince bankers that there is "a plan to properly pay employees in the future."  Somehow it is still hard to swallow the fact that the number one concern of highly compensated executives at a bank that punted $47 billion and required a $60 billion government injection, is the banks plan to pay employees "properly" in the future.  Maybe the truth is that they were just paid improperly in the past?  What if the bankers were told "in light of all of the political scrutiny and the lack of funds, we just can't afford to pay you any more than this small sum.  Feel free to pursue other, better opportunities."  Then what if nobody left?  

Perhaps a little perspective is in order?  Certainly it is difficult for anyone who is used to a certain lifestyle to adjust to new compensation expectations.  But the cycle will eventually turn, and banks will one day make money again.  Banking employees will once again be highly rewarded, although hopefully compensation will be adjusted to reflect risk assumed by the institution.  It is still far more lucrative to have a "low paying" banking job than a high paying job in almost any other industry, or to be unemployed in this economy.  In this economic environment, if you still have a job, maybe it's wise to just keep your mouth shut, work hard and wait for the next bubble.  

Unemployment Rises to 16-Year High

The jobless rate rose to 7.6% from 7.2% in December, while payrolls fell by 598,000, bringing total job losses since the recession started in December 2007 to 3.6 million.  Half of those losses occurred in the last three months alone.  Worse yet, when marginally attached and involuntary part-time workers are included, the rate of unemployed or underemployed workers actually reached 13.9% last month, up almost five percentage points from a year earlier.

Job losses were spread across most industries, with manufacturing cutting 207,000 jobs, construction axing 111,000, and the service sector cutting 279,000.  The lone bright spots were health care and education, which added 54,000 and the government, which added 6,000.

These numbers are bleak and demoralizing, particularly since they continue to get worse month after month.  There is no way to put a positive spin on it.  Now it's the government's turn to show its hand.  Whatever Mr. Geithner has to say on Monday, it better be good.     

Thursday, February 5, 2009

Headline Financial News 2/5/2009

  • Jobless claims jumped 35,000 to 626,000.  The total number of people collecting benefits jumped to a record 4.788 million.  Productivity rose a higher-than-forecast 3.2% in the fourth quarter, presumably because suddenly those with jobs become much more productive when trying to survive the next round of layoffs.
  • Credit card delinquencies climbed to a record high in January.  Payments at least 60 days late rose almost half a percentage point last month to a record 3.75%.  Late payments surged by 18% in the fourth quarter and charge offs were 40% higher than a year ago at 7.5%.  Late payments and defaults on credit cards are closely linked with levels of unemployment.  These numbers were produced by Fitch, the rating agency which noted that rising late payments and defaults on credit card loans would hurt the performance of securities backed by credit card receivables.  The good news is that the Fed is planning a program to lend against these securities since the market is currently frozen.  Guess who's going to bear the risk when delinquencies go higher?
  • Back in November, when AIG posted its $25 billion quarterly loss, I marveled at how on earth the insurance company lost nearly $12 billion in its securities lending unit.  Securities lending is the least complex short-term money making strategy that ordinarily generates a sliver of profit off of a large portfolio, generally with little risk.  Give me a week, and I could train a monkey to run a profitable $100 billion securities lending portfolio at a highly rated financial institution (i.e. you need cheap funding for the strategy to work.)  As long as you have a relatively smart person in charge of risk management, the strategy cannot fail.  The Wall Street Journal has a fine article detailing exactly how the boobs at AIG managed to lose so much money in securities lending.  They took a simple strategy, added a dose of subprime, mismatched the maturities (i.e. borrowed very short and invested in longer maturity highly illiquid paper), and voila! -  multiple billions in losses.  The best part is, the guy who ran the unit was paid millions and liked to write emails that said things like: "There are still a few people that do not believe in our mission...The time has come-if you do not want to be on this bus- it is a good time to get off...Your colleagues are tired of carrying you along."

Wednesday, February 4, 2009

Are MetLife's Earnings Really that Great?

Metlife Reported a 12% drop in fourth-quarter profit to $985 million or $1.20 a share.  Metlife's earnings included a $1.6 billion gain on successful derivatives hedges.  These results are super, right?  Operating earnings only down 12% from the prior year, which is not a loss, and it beat analysts estimates?  The problem is that operating earnings are really only a small part of the story at many banks and insurers and I'm surprised that analysts still cling to them in this environment.  The real issue is the balance sheet, namely other comprehensive income (OCI.)  OCI accounts for investment gains and losses on certain assets that do not flow through the income statement.  OCI is instead reflected in shareholder's equity.  As assets are written down to reflect "temporary" changes in the value of securities, other comprehensive income is either added to shareholder's equity if it is a gain or subtracted if it is a loss.  Book value, a measure of assets minus liabilities, will either increase or decrease reflecting, more or less, what the company's assets are worth.

According to Bloomberg's earnings report, Metlife's book value per share declined 23% over three months to $27.33.  Gross unrealized losses on investment assets widened to $28.8 billion from $16.7 billion.  By my calculations, I get a loss of $12.1 billion on MetLife's investment portfolio.  Now I ask you:  Who cares about $935 million in operating earnings, when the company's assets declined in value by over $10 billion?  

Government Imposing Executive Pay Caps, Cabinet Nominees Don't Like To Pay Taxes

President Obama plans to announce a pay cap of $500,000 on the compensation of top executives at companies that receive significant federal assistance in the future.  Any additional compensation will be restricted stock that won't vest until taxpayers have been paid back.  I find this measure to be entirely appropriate and am surprised that it only applies to companies that take "exceptional" amounts of bailout money in the future.  

Ordinarily, I don't think that government should have a hand in determining executive compensation, but in cases where taxpayers are stuck guaranteeing toxic assets and investing in failed companies that threaten to derail our economy, it's entirely appropriate that executive compensation is curbed.  Particularly since the current system for determining compensation within many US companies is corrupt and rife with conflicts.  I've always been amazed that shareholders allow corrupt and inbred boards to determine executive compensation, which is often egregious for many mediocre and poor performers.  When I read about severance packages that run in the hundreds of millions of dollars for CEOs that have been given the boot, I cringe and wonder why there isn't more of a furor from shareholders.  Why on earth do the boards allow ridiculous severance packages to be negotiated?  Executive pay consultants always offer some lame explanation claiming that CEOs bear significant risks and need to be adequately compensated.  I don't actually understand what risks they are talking about.  What exactly is so risky about accepting a job that pays millions of dollars, offers a private jet for transportation, pays insurance in case you screw up and need to go to court to defend yourself, often pays your taxes, and frequently distributes a huge lump sum if the company decides it doesn't need your services?  Furthermore, CEOs never have to give the money back even if they drive the company into the ground.  The model is: if you succeed, you are paid very well, if you fail, you are paid very well and shareholders are left holding the bag.  Our failed Wall Street institutions are fine examples of this absurdity.  The former CEOs of Merrill, Citi, Lehman, and Bear were all paid extraordinary sums of money during the boom.  Guess who was left holding the bag when the boom turned to bust?  So who exactly bore the risk?  I'll give you a hint: it wasn't the CEO.  So can we dispense with all of the highly paid compensation consultants once and for all who keep pushing for more and more egregious compensation packages because they earn a commission?  Surely a board is capable of negotiating without these clowns.

As for Obama's cabinet picks who have some issues with back taxes, I have only one question: Is it really that hard to find lawmakers who actually pay their taxes?

January Car Sales - Horrible

Just when you thought it couldn't get worse for the auto makers, it did.  According to the Wall Street Journal "Sales by the Big Three US auto makers plunged to the lowest levels in decades."  The level is so demoralizing that the Journal has abandoned its usual effort to find the precise year that car sales were this bad.  So we're left wondering if the "lowest level in a century" is just around the corner, assuming, that the government is willing to keep supporting Detroit.

Chrysler's US sales fell 55% compared to January 2008, while General Motors sales were off 49%.  Ford managed to eek out a mere 40% decline.  These declines were steeper than expected and were blamed on sharply lower purchases by fleet operators as well as the inability of consumers to obtain car loans.  Industrywide, car sales were down 37% to 656,976 from January 2008.  Not only was this the lowest total since December 1981 but it was the first time that US sales were lower than in China.     

Tuesday, February 3, 2009

Financial Headlines 2/3/2009

Some lackluster earnings results:
  • Dow Chemical swung to a fourth quarter loss on restructuring charges.  Dow reported a fourth quarter net loss of $1.55 billion on a 23% decline in revenue to $10.9 billion.  Analysts were expecting a profit of 7 cents on $13.37 billion in revenue.  The company announced 5,000 job cuts and plans to close 20 plants.  Doesn't this make you wonder how on earth this company planned to complete a $15 billion acquisition?  Nevertheless Rohm & Haas is mad and has filed a breach-of-contract suit seeking to force Dow to complete the merger.  Dow claims the credit crisis has "made it impossible" to seal the deal without "jeopardizing the very existence of both companies."  Yikes.
  • GMAC posted a miraculous profit on a $11.4 billion gain from convincing its bond holders to swap their worthless debt for some worthless equity so it could limp along a little bit longer.  Rest assured nothing fundamental has changed at the finance company, it is still bleeding cash out the wazoo.  Fourth quarter net income was $7.46 billion.  The auto-finance unit swung to a $1.31 billion loss while ResCap's loss widened to $981 million.  Oh, and GMAC received $5 billion in TARP funds.  Because why would Cerberus, the private equity fund that owns GMAC, need to pony up any more money when it can just get it from the government?  Awesome. 

Monday, February 2, 2009

Hybrids Raise Question For Insurers

Investors in Aflac, the insurance company with the hilarious duck commercials, were stunned a few weeks ago when the stock dropped like a stone on seemingly no news.  In-the-know investors were privy to an investment bank research report about hybrid securities which showed that Aflac had significant exposure to these types of securities and could face writedowns large enough to imperil the insurer's capital position.  Aflac predictably said that it was  confident with its capital position and now investors await the earnings report after the close today.

The Wall Street Journal has an article today discussing hybrid securities and their perils.  These securities combine characteristics of both debt and equity and grew into a very popular product during the credit boom when investors were starved for yield.  The securities offered yields of 0.6 to 0.7 above corporate bonds with the same ratings.  How could investors resist all of that extra yield without any extra risk?  The problem, of course, is that there was more risk with these securities and that the risks were mispriced.  The issuers of these hybrids, mostly banks, had the option to delay repayment on the bonds.  In December, Deutsche Bank opted not to repay its hybrid securities as it was cheaper for the bank to leave the debt outstanding rather than find an alternative source of financing.  Deutsche's move caused investors to dump the securities in December.  Fears of nationalization of the UK banks in January pummeled hybrids further, causing them to decline by 25% to 75%. 

Issuance in the hybrid market around the globe jumped from $32 billion in 2000 to $175 billion in 2007, with the size of the market estimated at $700 billion.  At the height of the credit boom, insurance companies were buying 30% to 40% of the issuance.  Consequently, insurance companies are set to suffer if these securities do not regain in value.  I'm not holding my breath.
In my opinion, the real issue here is when is all of this "discovery of hidden risks on financials' balance sheets" crap going to end?  Every couple of months, some sort of news of a financial product meltdown like this pops up and lo and behold, it was a $700 billion market and now these securities are down like 40% and some major bank or insurance company owns a boatload of them.  I pride myself on being fairly well informed on many exotic derivative products, yet I'd never heard of hybrids until a few weeks ago when Aflac got the beatdown.  But I expect surprises like this, which is why I haven't and wouldn't touch any financial company's stock with a 10 foot pole, no matter how "cheap" it gets.  I am so sick of listening to money manager boobs on CNBC talking about "cheap" insurance company stocks etc.  Sure they are.  If you can comb through their balance sheets and tell me exactly what it is that they own and how every single one of these securities would react under a variety of scenarios, including a possible depression, I might be willing to listen.  

Merrill's $15 billion fourth quarter loss was insidious for reasons that go beyond the absurdity of its bonus payouts (which will need to be tackled in a separate post.)  I still want to know how the hell Merrill lost $15 billion in the fourth quarter after John Thain had claimed several times that it had marked assets down to distressed levels in prior quarters.  I'm sure attacking Merrill for the bonus payments is more politically savvy for regulators, but I would offer that there may be issues with accounting fraud at that firm.  A steep yield curve, a zero overnight interest rate policy for the foreseeable future, and record wide spreads in the bond market which actually narrowed in December indicates to me that Merrill's losses should've narrowed instead of nearly tripling from the prior quarter.  It is highly possible that Merrill was marking assets way too high before the Bank of America merger.  

The problem with financials is that the mistakes from the bubble years were astronomical, and they own so much illiquid garbage that is blowing up left and right, that the worst offenders can't break-even despite the many gifts from the Fed and Treasury.  I suspect that hybrids are not the last of the "but we thought it was AAA" surprises that investors will be forced to confront.  But then again, if the government just keeps bailing out the banks, then it's the taxpayers that will be facing these surprises.