Administrative Note

I will be traveling for much of this week, so blogging will be sparse.  I will try to post if something crazy, catastrophic, or highly unexpected hits the tape.  Every time I take a quick vacation, some sort of large institution fails (i.e. I was in Tahoe when Bear went under, and LA when Fannie and Freddie were seized by the government.)  You might want to consider buying some puts if you're superstitious.  On second thought, the market ripped after Fannie and Freddie went into conservatorship, so maybe buy some straddles?  

Financial Headlines 3/31/2009

In bankruptcy news:

• Sun-Times Media Group files for voluntary Chapter 11 bankruptcy.  In a continuing sign of the rapidly deteriorating economics of print media, the publisher of the Chicago Sun-Times voluntarily threw in the towel.  The company will continue to operate its newspapers as it attempts to restructure and stabilize its operations.  More sad news for lovers of newspapers, myself included.
  

In near-bankruptcy news:

• More details emerged of President Obama's hardball tactics with GM and Chrysler.  In addition to forcing out GM CEO Rick Wagoner, and ordering Chrysler to do a deal with Fiat, the President hopes that dividing the companies into "good" and "bad" assets and potentially sending them into bankruptcy to purge their biggest problems is the solution for the US auto industry.  The general message?  Get your act together because you're not getting more money from the government until you significantly restructure.  My favorite part of the plan is the fact that Cerberus Capital will likely lose its entire equity stake in Chrysler.  I never quite understood why the government should bail a private equity firm out of its crappy investment,  even if it was in the interest of maintaining some sort of manufacturing sector in the United States.  
• General Growth Properties, the mall REIT that has managed to default on lots of debt without being forced into Chapter 11, has failed to win a reprieve from bondholders.  However, creditors have yet to force GGP into bankruptcy.  Why?  Perhaps because creditors realize that attempting to dump a bunch of malls into this horrible commercial real estate market would be disastrous.  Furthermore, General Growth's mall operations are stable and bondholders are hoping for a greater recovery outside of bankruptcy court. 
• GMAC and CIT have yet to win approval to issue government-backed debt nearly three months after winning approval to become bank holding companies.  No word on why the FDIC hasn't approved their applications, but CIT, whose debt implies borrowing costs north of 18%, is a little irked to say the least.  Without a cheaper funding source, CIT would need to sell assets, which is about as palatable in this market as attempting to sell a bunch of malls (see GGP above.)

Equity futures are higher for some inexplicable reason.  Perhaps they're just taking a breather from yesterday's pummeling.  But with a significant amount of economic data, bailout news, and earnings releases on the horizon, volatility is certain to stick around.

AIG Delays Funds on Land Ventures, Wreaks Havoc on Developers

AIG has cut or delayed payments to some AIG real-estate ventures, potentially leaving shopping centers and apartment complexes across the US short on cash to pay lenders and fund repairs and renovations.  Developers who have partnered with AIG are crying foul.  "Wait a minute!"  they proclaim "how come foreign banks and Goldman Sachs can use AIG as an ATM, via the government, and we can't?"  Naturally, a frenzy of lawsuits are in progress.

AIG's real-estate business, using its insurance premiums and working with third party investors acquired property on its own or via developers totalling over $23 billion.  When the unit joined with developers in the past, AIG's stature allowed it to close deals quickly.  Once the portfolio was acquired, AIG would provide money for renovations and would cover cash shortfalls.  What I find interesting about these deals is that AIG was responsible for covering cash shortfalls.  Developers more than likely thought these deals were lay-ups when the commercial property market was booming.  If AIG would cover the cash short-falls, then there was very little liquidity risk from doing a deal, and a developer probably didn't need to pay attention to silly little things like making sure cash flows covered debt service or coming in under budget on a deal.  I suspect AIG did many stupid real estate deals during the boom that only added to the commercial property bubble.  

The partnership with Mitchell L. Morgan is a prime example.  According to the Journal's account of the story, AIG teamed up with Morgan in 2007 after it had missed out on closing a "mega real estate transaction."  My hunch is that the deal-makers in AIG's real estate group were paid commissions based on transactions and not on how well the properties performed, otherwise, why would they rush into doing deals just because they missed out on closing a mega-deal?  In any event, the purchase of 16,800 apartment units with Morgan required that AIG pony up $120 million to renovate the properties.  After the government's $150 billion bailout in November, AIG's payments were delayed, wreaking havoc on the project.  According to the lawsuit filed by affiliates of the developer, if the partnership can't pay contractors, it could file liens on the properties which would trigger a default with the banks that provided the partners money to buy the apartments.  The Journal names Wachovia (now owned by Wells) as one of the lenders.  Affiliates claim they were told by AIG's top real-estate executive that "the current Federal Reserve funding arrangement with AIG does not provide for funding of AIG Global's commitments to its joint venture partners."  Geez, talk about unfair.  I can't believe the government isn't going to continue financing a bunch of crappy under-water commercial real estate deals.  

In Alabama, AIG halted payments it had made in the past as part of a 16-year partnership with Alex Baker, a Birmingham developer.  The partnership, AIG Baker, developed 20 million square feet of shopping centers, some of which (surprise surprise!) have struggled recently.  AIG's exit created uncertainty about whether payments would continue to be made on bank loans used to buy properties.  The Journal claims that if AIG isn't there to provide cash flow shortage payments to cover the $600 million in loans on the properties, it is going to be difficult for the partnership to cover its costs.  Apparently, some shopping centers are lacking tenants and are cash flow negative.  AIG is offering restructuring options but is not willing to continue funding the shortages.  Thankfully, AIG never contractually agreed to cover the cash flow shortfalls, it had only done so in the past so out of [multiple choice quiz] a.) broken calculator b.) good-natured disposition c.) Too much money flowing in from CDS premiums  d.) all of the above.  

What's funny (and yet also incredibly depressing) about this story is that clearly developers knew they could cram any deal through with AIG as a partner.  If you can partner with a deep-pocketed investor that agrees to cover cash flow shortfalls, why bother with looking at whether properties were cash flow positive?  For awhile, I marveled at how and why so many commercial real estate deals were getting done at ridiculous cap rates implying negative cash flow during the past few years.  I now have part of the answer: AIG was a giant ATM that provided capital for many financially dubious real estate investments.      

 

Wagoner Out as Government Forces Change at GM and Chrysler

No more Mr. Nice Guy.  President Obama moved to impose sweeping restructuring measures on GM and Chrysler.  GM's CEO Rick Wagoner will step down and the majority of its directors will be replaced.  The administration's auto task force, after a month of analysis (which surprisingly only took my toddler about five minutes), determined that neither company had put forward viable restructuring plans.  The government said it would provide Chrysler with capital for 30 days, allowing it to come up with a workable plan with Fiat.  If the two reach an agreement, the government would grant another $6 billion.  If not, Chrysler would be allowed to collapse.  Yes, you read that right.  The task force is not taking the hard line with Chrysler's CEO Robert Nardelli, he will not be forced to step down as the administration does not consider him an "auto insider."  Although an executive put in place by the private equity goons at Cerberus Management, where John Snow and Dan Quayle hang their hats, is certainly an insider by anyone else's standards, maybe he's just an insider with the previous administration.  Perhaps the auto task force believes that attempting to lead Chrysler out of this mess is punishment enough for any CEO.  

GM will be granted 60 more days of working capital during which time a revamped board and management must work out a much more rigorous restructuring plan than it submitted last month.  The administration officials said that the companies were burdened by inordinate amounts of debt that would have to be extinguished (again no surprise to my child, as her first words might have been "Ga ga, GM has too much icky debt, goo goo".)  The government will, however, guarantee all warrantees on new cars from either company to keep consumers from fleeing the brands.

This move by Obama's task force is interesting, to say the least.  It would imply that the administration has no interest in supporting zombie institutions anymore.  However, it has yet to take this type of action with the nation's struggling banks.  Is this merely a sign that the government is going to get tougher on the banks after the stress tests?  One can only hope.  Needless to say, the market isn't taking this news very well.  After all, government support is the only thing keeping the market afloat.  When it gets yanked, look out below. 

 

Financial Headlines 3/27/2009

President Barack Obama is seeking support from banking executives by inviting them all to the White House for a meeting of the minds.  The invitees are household names at this point; Vikram Pandit, Jamie Dimon, Lloyd Blankfein and other notables.  Apparently, the meeting will focus on stabilizing financial markets, boosting lending to business and consumers, reducing foreclosures, imposing regulatory overhauls on the industry, and making sure that banking executives are not taking to heart anything that the nutjobs in Congress are trying to do to thwart their compensation.

Some celebration is in order, if you're a bull, after a week of strong gains for equities powered by some marginally positive economic data.  Both new home sales and existing home sales were better than expected, although they remained at depressed levels.  While existing home sales rose 5.1% for February 2009, 45% of the sales were due to foreclosure activity.  The market needs to work through the massive inventory of distressed houses before supply and demand can come back into balance.  What is important is that properties are actually changing hands furiously in places like California where there is an enormous overhang in foreclosures left over from the boom.  It means that prices in those areas have more than likely reached a bottom.  This doesn't mean we're in for another huge spike in prices, but a stabilization would be extremely positive.  What is concerning is that outside of the distressed property sales, sales of new homes and existing properties are still very weak, which indicates that prices have further to fall, particularly in locations where affordability is still a major issue.

Another positive for the market was durable goods, which posted a rise of 3.4% following months of decline.  Also, mortgage interest rates have declined to record lows due to the Fed's aggressive balance sheet expansion activities which should be a huge boost to housing affordability and should spur some potential buyers off of the sidelines.

  

But troubling issues remain for the market.  The Financial Times reports that GM is working on the third iteration of its viability plan.  GM had until March 31st to present the plan and will more than likely need to use the one-month grace period provided for by the bailout agreement as it seeks to renegotiate with lenders and the UAW.  

The massive $8.6 billion City Center project in Vegas is preparing for a bankruptcy filing as MGM Mirage and Dubai World appear unlikely to make a $220 million debt payment due today.  A bankruptcy filing would halt construction and add to the growing landscape of half-built projects in Las Vegas.  

John Authers, in his excellent column, points out that a massive disconnect remains between equities and credit markets, despite all of the government efforts aimed at boosting credit markets.  According to a Deutsche Bank report, the implied default rates derived from corporate bond spreads are 38% in Europe, 40% in the US, and 51% in the UK.  These levels are all worse than in the Depression.  Mr. Authers offers two explanations for the divergence between equities and credit: either the credit market is suffering from illiquidity that is distorting the prices from their fundamental values, or equity investors have been smoking crack (my interpretation, not his exact words.)  But it is impossible for both to be right.  The good news is, as I've noted before, if this really is just a liquidity problem, then Geither's toxic asset plan should work.  If not, well, equity investors are in for a world of hurt.

Commercial Property Report Courtesy of WSJ

As regular readers of Mock the Market know, I like to blog about commercial real estate deals gone awry.  For one thing, I find it incredibly amusing that many of the same developers who lost their empires in the early '90s are knee-deep in doo doo this time around as well.  It's as if they are a bunch of five year olds who have no ability to predict the consequences of their over-leveraged actions, even though most of them are seasoned real estate developers who have been in the business for over 25 years.  More importantly, I am a big believer in utilizing anecdotal evidence to predict larger economic trends.  The commercial property crisis has been brewing for some time and while the actual delinquency and default rates were extremely low until very recently, all of the high profile blow-ups, foreclosures, and legal maneuvering have been pointing to an impending crisis with a big large flashing arrow.

The Wall Street Journal article entitled "Commercial Property Faces Crisis" is good summary of how quickly the commercial property market is unraveling.  Delinquency rates on $700 billion in securitized loans backed by commercial property more than doubled since September to 1.8%.  It is just short of the highest delinquency rate reached during the last downturn and we're just getting started.  Foresight Analytics estimates the US banking sector could suffer as much as $250 billion in commercial real-estate losses in this downturn, compared to $48.5 billion between 1990 and 1995.  The market is nearly three times as big now as in the early 1990's, estimated to be roughly $6.5 trillion in value financed by $3.1 trillion in debt.  While the leverage ratio doesn't sound particularly high overall, there is little doubt that many of the loans negotiated in the past three years, when the market was surging, were structured with loose lending terms, assumed impossibly high cash flow levels, and required little equity from the owners (i.e. a recipe for disaster in general, but particularly acute in an economic downturn.)

The article talks about the Fed and Treasury's struggle to structure the TALF to alleviate the financing issue that has halted the ability of developers and investors to refinance or do new deals.  But again, if this were merely a liquidity problem, the TALF might actually work to revive the commercial property market.  The problem is that valuations were too high, cash flows are dropping off a cliff as the economy suffers from a steep downturn, and the best financial resolution for many a developer, or property owner is to walk away.  The alternative is to cough up more equity into the deal.  But as every successful real estate developer knows, it's far easier to walk away and do the whole dance again in a few years when the market recovers.  If this wasn't the case, names like Donald Trump, Harry Macklowe and Ian Bruce Eichner wouldn't be experiencing deja vu right now.  Unfortunately, no amount of financing from the government can solve this fundamental problem.  Frankly, I would prefer it if the Fed required that the equity investors cough up more equity to support the debt that is going to be financed by the Fed in the TALF.  Unfortunately, given all the defaults and bank failures on the horizon, the government will more than likely be holding RTC-style auctions once again.      

Why Is Treasury Seeking Power to Seize Financial Institutions?

The seizing of insolvent banks is Sheila Bair's job.  After all, the FDIC is tasked with seizing insolvent banking institutions and protecting depositors.  So why is Treasury looking for new powers?  In their appearance before Congress yesterday, Tim Geithner and Ben Bernanke asked for new regulatory powers over financial services institutions, including non-banks, that would allow them to seize ailing institutions if necessary.  The timing of this action is interesting, to say the least.  Why Mr. Bernanke wasn't in front of Congress a year ago, after Bear Stearns nearly collapsed, or six months ago, after Lehman's failure, is a bit of a mystery.  It seems like the Fed has been talking about the need for a systemic regulator and an orderly method for unwinding complex financial institutions for some time.  Yet nothing appears to have happened so far, despite our financial institutions teetering on the brink several times within the past year.  Why is Mr. Bernanke finally getting his act together?  I suspect it is because the ability to seize large financial institutions and Tim Geithner's toxic asset plan are closely linked.

The Financial Times has a front page article claiming that banks face large writedowns in the toxic asset plan.  While the equity markets partied after the unveiling of Tim Geithner's new plan, considerable concerns remain about the enormous bid/ask spreads between what investors might be willing to pay for distressed loans and where the banks are carrying them on their balance sheets.  Although the leverage provided by the government is theoretically supposed to raise the bids, credit markets did not rally nearly enough after the announcement to close the yawning divide.  Consequently, Mr. Geithner's plan has the same fundamental flaw that it had when it was Mr. Paulson's plan: if banks are forced to sell at these prices, they would have enormous holes in their balance sheets and would need to raise more capital.  Some banks are better capitalized than others, and the stress tests have been designed to determine which banks can withstand the writedowns.  Although quite frankly, you don't need a stress test to tell you which bank is more distressed.  A $1 to $3 stock price is evidence enough.  

But if you pair the stress test, with the toxic asset auction plan, what do you get?  Some banks that'll make it, and some that won't.  What to do with the banks that won't?  You can either keep them afloat or you can seize them.  Is it any wonder then that Bernanke is finally serious about having methods in place to deal with an orderly unwind of large financial institutions? 

Dubai World Sues MGM Over Vegas Property Venture

Of all the large problems that Tim Geithner's plan intends to solve (i.e. not enough risk currently assumed by the taxpayer, budget deficit way too small, future risk of US currency crisis not quite alarming enough, runaway inflation too remote of a possibility etc.), here's one that it won't fix: the collapse of half-built commercial property development projects agreed to during the bubble.  Case in point:  Dubai World and MGM Mirage's $8.6 billion City Center Project that is currently under construction.  If there is anything that Dubai World, the developer of the manmade palm-shape island in Dubai, loves more than cranes scattered across a half-built landscape, I have yet to discover it.  But I suppose that the sight of the half-built City Center project and the reality of all the money required to finish construction has finally caused Dubai World to reassess the situation.  

The ambitious joint venture is running into major financing problems as the gambling industry threatens MGM Mirage's chances of fulfilling its obligations.  In an effort to protect itself, Dubai World is suing to limit its exposure to the expensive project.  Dubai World has asked the court to free it from making future payments and fulfilling other obligations.  It blames MGM Mirage for massive cost overruns and it has indicated that it will probably not make a $100 million payment on the City Center project that is due Friday.  Failure to make the payment could halt construction on the project and push it into bankruptcy.  Dubai claims that the current path of the project is unsustainable given MGM's financial situation, which is a very good point.  MGM Mirage won a temporary reprieve just last week from its lenders but warned that it faces potential default on loan obligations due in May.  Dubai's main beef is that it has been asked to make capital contributions far in excess of the levels originally estimated by MGM, the cost overruns to date are over $1 billion, despite a scaling back of parts of the ambitious project.  Now it's up to the court to decide how this debacle is resolved.  

The commercial real estate landscape is filled with half-finished large-scale projects across the country envisioned during a much better economy and financed on extremely friendly terms.  Investors and developers are hiring lawyers and preparing themselves for painful discussions with lenders.  One can only hope that the debt on this kind of debacle doesn't somehow wind up financed in a non-recourse loan in the TALF, because as a taxpayer I want no part of it.

Should the FDIC Guarantee Anything Other Than Bank Deposits?

I've ruminated a bit more about the toxic asset plan unveiled by the Treasury Department this morning and read many interesting comments on other blogs.  I have finally honed in on the one point that irritates me the most about the plan: the FDIC's promise to guarantee debt issued by the entities that are purchasing loans under the legacy loans program.  The FDIC is already guaranteeing debt issued by many of our banking institutions.  However, the FDIC's primary purpose is to guarantee bank deposits.  This is what I want my FDIC to do for me.  This is ALL I want my FDIC to do for me.  The FDIC is very good at seizing failed banking institutions, disposing of any salable assets, and making certain that insured depositors are made whole.  The FDIC eats any ensuing losses through its insurance fund.  I like this system as it keeps depositors from panicking and withdrawing their funds from our nation's banks.  Given all of the stress in the financial system, the fundamental belief in the FDIC's ability to guarantee bank deposits has alleviated this type of panic for the most part (IndyMac and Wa Mu to a certain extent excepted.)

As a depositor, I'm a little pissed off that my claim on the FDIC's insurance fund is being diluted and shared with bond investors who are free-riding off of the FDIC's guarantee of bank debt, and now the FDIC's guarantee of the Legacy Loans program debt.  If there ever is a massive run on the US banking system, am I going to be standing in line with PIMCO's Bill Gross, waiting to withdraw my funds from the FDIC?  I fully understand that the FDIC can borrow from the Fed and the Fed can borrow from the Treasury and we can just keep printing an unlimited supply of money.  At some point, however, shouldn't the US government come up with its own capital structure, given how much every government organization is borrowing and is up to its eyeballs in private sector guarantees?  Is FDIC debt senior to the Fed's?  What about Fannie and Freddie's?  How about Treasuries?  When does it all get to be too much?  How can I be certain that I'm holding the senior debt of the US government?   

Toxic Asset Plan: Solution or Not?

The future stability of the global financial markets rests on Tim Geithner's weary shoulders.  Will his plan to partner with private investors to purchase toxic assets finally unclog our banks' balance sheets and allow them to become profitable institutions again?  Although the plan relies on private investor participation, the government will be offering significant support via financing through the Fed and FDIC and capital injections from Treasury.  Participation in the program is anticipated from individual investors, pension plans, insurance companies and other long-term investors.  

The program will address both legacy loans and legacy securities.  Under the legacy loan program, banks will identify assets they wish to sell, the FDIC will conduct an analysis to determine the amount of funding it is willing to guarantee.  Leverage will not exceed a 6-to-1 debt -to-equity ratio.  The legacy securities program will grant non-recourse loans to investors to fund purchases of legacy securitization assets.  Eligible assets will include non-agency residential MBS that were originally rated AAA and outstanding CMBS and ABS that are rated AAA.    

Whether this plan finally works to get the market back on its feet is dependent on the answer to one very serious question that is furiously debated among economists and investors:  Is our current crisis a liquidity crisis or a solvency crisis?  If you believe that this is purely a liquidity crisis (i.e. the intrinsic value of these assets is higher than the current mark to market) then this plan will definitely work.  Investors will have access to leverage from the government, they will purchase assets at "cheap" prices, the banks will be relieved of their lousy investments and will be free to raise private capital again.  Those that purchase the "depressed" assets will make all sorts of money and the taxpayer will share in the gains.  The banks will recapitalize, pay back the TARP and condo flippers and homebuilders can return to their lucrative careers.

If you are in the "insolvency" camp, and you believe that the mark-to-market values reflect reality, or in some cases are optimistic, then this plan fails to solve the problem.  It merely becomes a large transference of risk from the shareholders and bondholders of banking institutions to the taxpayers.  Sure some private investor money will be on the table, but it will be a small slice compared to all of the taxpayer funding.  

I hate this idea, much as I did when it was first introduced several iterations ago when Paulson was still the Treasury Secretary.  What I think the government should be doing instead is preparing itself for large scale liquidations of institutions once they fail, and mass auctions of toxic assets (and buildings, and houses etc.) when they take over failed institutions.  The RTC never had to pay for the assets it auctioned.  It acquired them when all of the Savings and loan institutions failed.  Investors showed up because the opportunities to pick up assets for pennies on the dollar were enticing.  The government is now trading with itself.  It is invested in the banks already, it has an incentive to make sure that the banks get the highest prices possible, but it also doesn't want to pay too much, so it is in a conflicted position as an investor on both sides.  It seems that either way, we lose.

Granted, this is a much bigger crisis than the S & L crisis.  But I still don't think that the taxpayer should be in the business of assuming risk.  Frankly if buying assets at these levels was the investment opportunity of a lifetime, it would've already happened and investors would be piling in.  There's a reason why private investors won't touch this stuff with a 10-foot pole without government assistance: because even at these prices, tremendous risks remain.

Equity futures are surging on the news.  Once again, everyone is excited about this plan finally being the plan that gets us out of the mess we're in.  I'm skeptical to say the least, but I certainly hope that I am wrong.      

Another Hedge Fund Bites the Dust Amid Suspicious Activity

The Financial Times reports that Weavering Capital collapsed over a $637 million derivatives position.  If this were just another unfortunate gamble on a derivatives contract that blew up in Weavering's face, the news would've never hit the FT.  Who really cares about another small hedge fund forced to close its door due to bad bets on the market?  This particular derivatives trade, however, was transacted with an offshore entity that was controlled by the fund's founder and chief executive, Magnus Peterson.  Trading with yourself?  Never a good idea, but at least you always come out a winner.  COO Chas Dabhia, one of the few involved in the fund that was not related to Mr. Peterson, discovered the dubious trade a week ago, froze Weavering's flagship fund and called in PwC to investigate.  The fund was put into liquidation yesterday by administrators when it was determined that the claims on the trade could not be paid.  The head of hedge fund restructuring at PwC said that he could not comment on who at Weavering put the trade in place or what it was for.  I'm pretty sure even my toddler can tell you what it was for.

Although this is a small hedge fund, the story of its demise is curiously similar to the Madoff scandal in several ways.  First, the fund had posted "solid returns" of 10-12% a year for the past five years.  Second, the problem was triggered by investor requests to withdraw funds that could not be met.  Finally, on the board of the UK company were a bevy of relatives of Mr. Peterson's including his wife, his brother and stepfather.      

Chuck Rangel Sums Up the Country's Tax Problems

Dealbreaker has the video of CNBC's Erin Burnett and Mark Haines interviewing Chuck Rangel on the bonus tax bill that the House is trying to pass today.  I try very hard to avoid paying attention to politics.  That has obviously become impossible, as government intervention is so rampant in the markets that an active trader and investor has to try to guess what the government will do next.  My main reason for hating politics and most politicians is that they have zero forecasting abilities and are always trying to govern retroactively.  Much of the credit crisis could've been prevented with the tiniest bit of intelligent legislation.  But since Congress was too busy investigating steroid abuse in baseball at the time, an obvious national epidemic that had to be resolved immediatly, it couldn't bother with any legislation that could've limited leverage on Wall Street, mortgage fraud, Fannie and Freddie's accounting problems, and the list goes on and on.  

Using the AIG incident as a tool to retroactively tax employees at all Wall Street firms that were coerced into taking money from the government, at a 90% tax rate, is typical political pandering.  It doesn't solve any of our problems but makes politicians look good to their angry constituents.  I predict that the first thing that happens if this legislation passes is that Goldman Sachs immediately hands the government $5 billion dollars, no doubt from the AIG collateral it received directly from the Treasury and the Fed when it was paid billions in the last government AIG bailout.  See?  Problem solved.  Other banks that can will pay the government back.  The rest will have a bunch of very angry employees to deal with who will prove how much their talent is really worth by trying to jump ship.  

In any event, the following dialogue sort of sums up why politicians can be so distasteful.  When Mark Haines questions Rangel's own tax issues, the congressman responds with the following line (and I am not making it up): "Well I wouldn't think that you would know what they are since what I did or did not is being investigated by a committee by me so what you're doing is reporting on what a reporter says because you have no clue as to what problems if any I have..."  At least it's somewhat reassuring that his problems are being investigated by a committee by him.  But certainly this qualifies him to weigh in on tax legislation...     

     

Fed Announcement Prompts Bond Market Party

If you think that the rally in financials for the past few days has been a spectacle, and I do, it's nothing compared to the radical move in the bond market today.  The Fed announced that it would buy $300 billion in Treasuries and purchase an additional $750 billion of mortgage-backed securities.  The intention is to force down interest rates so that homeowners can refinance into lower monthly payments.  The 10-year note dropped an astonishing 50 basis points, which is one of the largest moves I have ever seen.  

Equities initially staged an impressive rally, after being down for most of the day until after the Fed announcement.  Gains have been tempered a bit as stocks have grown tired of racing uphill for so many days in a row.  Financials, however, have held on to very impressive gains.

The Fed is aiming its spigot in the wrong direction, in my opinion.  Demand for Treasuries isn't really the problem and pushing down the rate on the 10-year note doesn't really help solve the issue of the decline in the fundamental value of many riskier assets that were purchased with borrowed money at the peak of a very frothy market.  The assets won't generate the cash flows to service the debt.  Furthermore, I still don't understand the excitement over the Fed purchasing Treasuries when it has to issue a boatload of them to finance our growing deficit.  Technically it's just selling Treasuries to itself.  But the market is impressed, for now at least.  Whether this move finally filters through the economy and we see some legitimate improvement in economic fundamentals is anybody's guess.  But the fact that this is the largest single-day drop in the 10-year note's yield since October 20, 1987 is eerie, to say the least.

      

  

 

Fannie Says "No Condo Financing For You!"

Perhaps all of the builders frantically breaking ground on multi-family units in the Northeast should've checked in with Fannie Mae.  The Wall Street Journal reports that Fannie is adding restrictions to its condo financing programs.  Fannie used to guarantee mortgages where 51% of the units in a building had been sold but is raising the level to 70%.  Furthermore, Fannie will no longer back loans for sales in buildings where 15% of current owners are delinquent on home owners association fees or where more than 10% of the units are owned by a single-entity.  Fannie says that the new rules protect borrowers (i.e. from their own stupidity) from buying units in buildings that have a high risk of failure and also protect the taxpayer from throwing good money into troubled developments (i.e. we've already punted enough on other crappy investments.)  Additionally, both Fannie and Freddie are raising fees on condo buyers (i.e. we'll make it all back on fees!)

The timing of Fannie's announcement is not particularly favorable for developers hoping that low interest rates will make a dent in the current glut of new condos for sale.  The US finished 2008 with a supply of condos large enough to absorb 14 months of demand.  Furthermore, the supply is set to increase by about 28% this year as 93,000 units are completed nationwide.  A bankruptcy lawyer representing a developer in Chapter 11 says "It's not that there's not demand; you just can't get the financing."  I find this statement to be very amusing.  I'm quite certain that everyone in America would love to have a shiny new condo, probably several shiny new condos, and would gladly finance them with no money-down interest-only loans, thereby creating unlimited demand for condos.  In fact, this is where all of that demand for condos a few years back actually came from, a bunch of people who couldn't afford them without exotic financing.  Developers now have to adjust to more normal demand levels.  The growing disparity between the price of renting and the price of owning over the past few years should've been a warning to developers that actual demand for housing didn't support the runaway prices of condos.  But it was far too convenient to ignore the signs and continue building as long as the party lasted.  Well, the party's over.  Unfortunately, we all have to pay the tab now.    

Should GE Mark to Market?

One of the highlights on the economic calendar for the week is GE's investor update tomorrow.  The conglomerate has been battling (much-needed) criticism over its opaque balance sheet, that is packed to the gills with assets.  Certainly, in a bull market, investors are not likely to question whether asset valuations are representative of market prices.  But in an an economic environment where asset values are declining, a leveraged finance firm needs to provide reassurances to its investors that its valuations reflect reality.  This is particularly true if the firm used to rely on selling assets out of its finance arm into a rising market to boost earnings.  

GE has a $34 billion commercial real estate investment portfolio that it does not mark to market.  According to accounting rules, the company doesn't have to mark to market because it is in a hold-to-maturity portfolio and 80% of the properties are not secured by mortgages.  This is a fair point, and I would accept this explanation if it weren't for the fact that GE was flipping properties with the best of them during the commercial real estate boom to boost earnings.  According to Real Capital Analytics, in 2007 GE sold $7 billion of real estate world-wide but acquired $16.6 billion in the same year.  Since 2007 was the high, GE was able to conveniently book significant profits on the sales, while simultaneously paying too much to double down on real estate.  If GE were just really bullish on commercial real estate and genuinely planned to hold to maturity, it would've had no reason to sell any properties in 2007.  Clearly, this was an earnings massaging maneuver that is no longer available to the company.  So, yeah, GE will definitely be holding to maturity now (i.e. no buyers).  The properties that GE purchased in 2007 are down at least 30%, assuming anything ever trades in the commercial real estate market again on a valuation basis.  The Wall Street Journal is filled with examples of the shocking rise in vacancies in several of the large buildings that GE purchased at the peak.  Apparently, GE has chosen to estimate that the value of its commercial real estate holdings will fall this year by 1.5%.  This seems incredibly hard to believe.  In fact, once I read this line, I rolled around on the floor laughing for a bit.  The folks at GE don't seem to understand that even if they don't think they need to mark to market, the market will do it for them.  But I give them major props for finally offering transparency to their investors.      

When All Else Fails, Just Change the Rules For Banks

The Fed announced a two-year delay of new capital requirements for bank holding companies that otherwise would have gone into effect later this month.  The new rule would've required bank holding companies to deduct goodwill (i.e. meaningless accounting plug) from the sum of core capital elements in calculating the amount of restricted capital that would be included in Tier 1 capital.  Furthermore, bank holding companies can continue to include cumulative perpetual preferred stock and trust preferred securities in Tier 1 capital up to 25% of total core capital elements.

In other let's-just-change-some-rules-to-keep-our-banks-solvent news, FASB is proposing changes to mark-to-market policies.  The proposed changes would allow companies to use "significant judgment" in valuing assets.  Some might argue that it was a significant lack of judgement that got us into this mess, but apparently judgement has improved significantly in the past year so that we can trust the clowns marking the books.  Companies would be able to apply the revised rule to their first-quarter financial statements.  FASB will be voting on the proposal April 2nd.  This might explain why all the bank CEOs have come out with such bullish assessments of their "profitability."  If you get to make up your own valuations, then profits are easy to come by.  I'm not sure when the last time was that the ostrich strategy worked for anyone, but maybe someone can call Japan as see how it served them in the '90's?     

Financial Headlines 3/17/2009

In a rare bit of good news, housing starts unexpectedly rose in February from a record low, on a rebound in condos and apartments.  Work began on 583,000 homes, a 22% increase from January.  Building permits, however, rose a mere 3% to a 547,000 annual pace.  The increase in housing starts was led by an 89% surge in the Northeast.  I'm not sure what they're so excited about in the Northeast to prompt the surge, but I'll take it as good news that the surge wasn't in Florida.

Meanwhile, PPI rose 0.1%, less than estimated by economists, with the core rising 0.2%.   Year-over-year, the PPI is down 1.3%.

Credit card defaults rose to a 20-year high.  Calculated Risk highlighted some of the jarring increases in charge-off rates from major issuers:  AmEx rose from 8.3% in January to 8.7% in February.  Citi's default rate soared to 9.33% from 6.95%.  Chase rose from 5.94% to 6.35% and Capital One rose from 7.82% to 8.06%.  The rate of change of these numbers from month to month seems astonishing to me.  Calculated Risk wonders what indicative loss rates the government will be using for various asset classes in its stress tests on banks.  Given how high these rates already are, we may have already reached extreme levels, and the government might have to revise higher its worst case scenario.

The focus of the markets has now shifted from whether our largest banks will survive (the government has indicated that they will, no matter what) to how bad this recession/depression is going to get.  Those that believe in the second-half recovery theory, because all of the crazy monetary and fiscal stimulus is eventually bound to work, can make a case that stocks are cheap.  Those who believe that it's impossible for the economy to recover so quickly from the bursting of such a huge credit bubble can make an argument that even if the government is set to continue to pump money into our banks, it will wind up diluting shareholders so much that the equity will become worthless.  Zero Hedge discusses the idea of "creeping equitization", where the government doesn't inject new capital but just continues to move down the capital structure, forcing conversion of preferred shares (i.e. Citi), followed by sub-debt, followed by senior debt, etc, into common shares.  Sort of a lose/lose for equity holders in either scenario.

    

Economic numbers matter more than ever, as investors attempt to come up with some sort of reasonable estimates for the length of the recession, while accounting for all of the various attempts by the government to speed through the downturn.  Continued volatility is the only certainty.

 

AIG: Your Tax Dollars At Work

The Wall Street Journal has a great article today filled with all the gory details of how AIG has blown through the $173 billion (and counting) in government bailout money.  AIG was pressed to release the list of beneficiaries of the government's largesse, which included mostly large banks and brokers that were counterparties to AIG on its massively toxic portfolio of credit default swaps or had borrowed from its securities lending unit.  Goldman, surprise surprise, was near the top of the list, receiving nearly $12 billion in total, $8 billion from the credit default swaps.  Rounding out the top five are Soc Gen, Deutsche Bank, Merrill Lynch, and UBS.  In total, between September 16th and December 31st, nearly $120 billion in aid has been distributed in the form of cash, collateral and other payouts to banks, municipalities and other institutions in the US and abroad.  I watched Bernanke on 60 Minutes last night, and he seemed like a very even-tempered gentle soul, but even his right eye began to twitch when he spoke of the anger he felt when forced to bailout AIG.  I don't know what would've happened to the market and economy if AIG would've gone under, but I'm starting to wish Bernanke would've had the balls to try it.

If large government transfer payments to banks that have already received bailout money from the government aren't enough to raise your ire, there's always the bonus issue to fall back on.  You see, even if you have been laid off, and watched your stock portfolio get creamed because you listened to your jackass broker from Merrill tell you that stocks were good for the long haul, you can always take comfort in the fact that some guy in AIG's Financial Products Group that was partially responsible for $40 billion in losses, is still getting a multi-million dollar bonus.  AIG's CEO Mr. Liddy, in a letter to Tim Geithner, expressed dismay at being contractually obligated to pay out $170 million in bonuses to 370 employees of the financial products group this week.  Apparently, these retention packages were put in place at the beginning of 2008, so that all of that purported talent didn't flee to greener pastures, and AIG supposedly legally has no choice but to pay them.  I have an idea:  Back in February of 2008, Pricewaterhouse Coopers found "material weakness" in AIG's reporting and forced the company to take a $9 billion write-down on its CDS portfolio.  Before the auditor pointed out the weakness, there was a large discrepancy between where AIG was marking its CDS (i.e. mark to model and not reported in earnings) and where AIG's counterparties were marking the CDS (i.e. mark to market.)  So cash was flowing out the door in the form of margin calls from counterparties but AIG was not reporting the hit to earnings because it claimed the losses were merely temporary.  Pricewaterhouse pointed out its discomfort with the discrepancy and forced AIG to take a hit to earnings.  My interpretation of this situation is that the retention packages were negotiated when managers in the Financial Products unit realized that they would have to take a big hit and probably wouldn't get paid if the unit showed a loss.  So they negotiated guarantees with the boobs that were running the company at the time.  What does this imply?  I think it's called accounting fraud.  Didn't we create laws after Enron, Worldcom and Tyco so we could clawback egregious compensation?  

In any event, if nothing else, since AIG is now 80% government owned, the government should at least do its citizens the favor of providing a list of the names and addresses of all financial products employees that received a bonus in 2008.  Then they can mail everyone in America a roll of toilet paper and we can take matters into our own hands.   

Market Rally Peters Out

This bear market rally has been a real head scratcher for K10.  While sentiment was incredibly negative at the end of last week and the market was "obviously" due for a bounce (which I can confidently say in hindsight,) it's still hard to fathom how quickly sentiment turned on the future prospects of the financial sector.  Remember last week, when everyone wanted to tar and feather Vikram Pandit and nationalize the banks?  All of a sudden, the fact that Mr. Pandit thinks Citi will be profitable (excluding those pesky and unimportant write-downs and credit loss provisions) meant that all of this nonsense about job losses and depressions was meaningless and everything was fine.  This prompted a near-doubling of Citi and Bank of America's stocks prices, and some fairly extraordinary moves higher in other financial stocks.

What to make of all of it?  And what is behind the crazy shifts in sentiment?  How is it possible that JP Morgan can be a $15 stock one day and a $24 stock a few days later without any fundamental change in the financial landscape?  Without any real resolution to the underlying problem of too much debt piled onto an economy whose fundamentals cannot support the burden?  Sure the bank CEOs are optimistic, but does anyone remember a year ago when all of these same clowns were uttering all sorts of "worst is over" crap that prompted Mock the Market to mock them relentlessly?

Maybe this time they really are right.  Maybe we've finally turned the corner.  I have a hard time believing it, since I still think the worst is yet to come for commercial real estate and private equity backed companies.  Many more banks will go under as the economic situation hits the fan and Sheila Bair will be calling the Fed and asking for a loan before summer, I'd wager.  I'm bearish on the REITs and insurers for reasons stated above.  I have no idea if our banks are insolvent, and enjoy reading all of the intelligent commentary on economic blogs that support either view.  My reluctance to buy bank stocks even at these levels is based on the fear that they might face the same fate as the UK banks, two of which are 75% owned by the UK government.  As I've stated before, it is a binary trade.  Given that possibility, it's hard to make a case for picking a bottom in any bank stocks.  Best just to wait and see if they make it, and buy other stocks which will benefit as the economy turns, assuming, of course, that you are dying to buy stocks.    

I tend to believe that much of the volatility we are witnessing is tied to short volatility positions on large derivatives desks that are forced to sell stocks at the lows and buy them at the highs.  This, along with short squeezes exacerbates the moves.  That is my best guess.      

Pay Consultant Opines About Future of Wall Street Comp

According to Alan Johnson, who runs a compensation consulting firm and clearly has a great PR agent, Wall Street employees' base salaries may double as bonuses shrink.  I agree with half of that assertion.  Bonuses are definitely going to shrink, since banks are posting gargantuan losses, and are dependent on government guarantees on bank debt and TARP funds to stay afloat, but I'm not so sure about the part where he thinks base salaries will double and triple.  Mr. Johnson, whose own compensation is dependent on Wall Street continuing to collect fat paychecks, appears to be having a hard time accepting reality.  Wall Street's compensation system of miserable six-figure salaries coupled with bonuses delivered at the end of the year, was designed to be flexible for a very important reason; because the industry is cyclical and employee compensation is the largest expense for the firms.  Raising salaries significantly doesn't make any sense from a business perspective, and is likely to greatly irritate shareholders and regulators.  However, according to Mr. Johnson "Regulators are either requiring it or imploring people to do it.  Their belief is that part of the reason that firms got in trouble was they had an excessive focus on bonuses because salaries were too low to live on."  I'd love to hear which regulator Mr. Alan is attributing that quote to because Barney Frank or Andrew Cuomo would love to have a conversation with that guy.  In the real world, as Wall Street firms continue to cut costs, they will have little incentive to pay outsized salaries to anyone, since it will be very easy to hire from a wide range of unemployed bankers desperate for a job.  In Mr. Johnson's fantasy world "If you've made millions, to have a $250,000 salary is kind of silly."  I suppose it's almost as silly as losing billions, needing government guarantees and capital injections, and still expecting a paycheck. 

Freddie Mac Posts $23.9 Billion Loss, Requests $30.8 Billion From Treasury

Perhaps the best thing that can be said about Freddie Mac's $23.9 billion loss is that it was positively paltry compared to AIG's $61 billion blow-out quarter.  While some might use the term "blow-out" to refer to an unexpectedly positive surprise, I like to use the floor trading vernacular, where a "blow-out" refers to a catastrophic loss.  In both AIG and Freddie Mac's case, the losses truly were catastrophic.  Were it not for government support, both AIG and Freddie would be a distant memory to the 25% of the US population that might be peddling apples from their apple carts today.  Fortunately, Freddie can continue the incineration of capital because it can probably get an unlimited supply from the Treasury.  Or unfortunately, depending on your perspective.

For all of 2008, Freddie reported a loss of $50.1 billion, compared with a year-earlier loss of $3.1 billion.  The losses over the past two years exceed the total of about $42 billion earned by the company from 1971 through 2006.  The latest capital infusion will increase the government's holdings of senior preferred stock in Freddie to $45.6 billion.  Freddie will pay the Treasury a 10% dividend, or $4.6 billion.  Freddie's annual profit has exceeded that amount only twice since 1971.  Translation?  Game over.  Is it any wonder that David Moffett, who served as Freddie's CEO just quit?  I wouldn't want to be delivering this kind of news indefinitely either.  But with sentiment turning ridiculously positive in the past two days, I'm sure Freddie's earnings are bound to inspire another 6% rally in the S&Ps.   

Some Thoughts on the Home Builders

The Wall Street Journal has an interesting story this morning that summarizes the main issue facing the homebuilders: a glut of housing inventory, some of it from foreclosed properties in their own developments.  The article has examples of new homes built as little as two years ago in new home developments that are now in foreclosure and offered at steep discounts to nearly identical houses in the same development.  One example is in the Inland Empire of Southern California where the foreclosed house is offered at $229,900 compared to a nearly identical house offered by the developer for $299,000.  Fortunately, the builders have spin on their side, as the article is filled with quotes such as "Our brand-new homes appeal to the buyer who wants up-to-date features and a chance to make their own selections like carpeting and paint colors" from a spokesman at Pulte.  Even better is the one from the Centex CEO that claims "In general, we try not to compete with foreclosures.  It's not all about price, it's about value."  I've always thought that price and value are somehow correlated, but maybe I'm wrong.  I'm fairly certain, however, that those buyers in the market for a house in the $229K price range will likely calculate the cost of a new carpet and some paint, if they happen to hate the current choices in the abandoned house, and it will equal less than $70,000.  That is a value proposition if I've ever heard one.

Meanwhile, in RealityLand, Hovnanian posted a worse-than-expected loss of $178.4 million for its fiscal first quarter, compared to $130.9 million in the same quarter of last year.  Revenue tumbled 66% to $373.8 million.  Who does the CEO Ara Hovnanian blame for its lousy quarter?  Why, the government, of course: "Given the lack of steps taken by the federal government to address housing demand, prospective homebuyers are still faced with making the decision to buy a home against an exceeding difficult economic backdrop."  While its true that if you ignore the $750 billion in TARP funds shoveled into banks to keep them lending, the multi-billions in mortgage modifications enacted, Operation "Hope for Homeowners", the $200 billion conservatorship of Fannie and Freddie, the bailout of credit unions, extension of the Federal Home Loan Banks borrowing ability from the Fed, the TALF, TAF, TSLF (insert 15 more acronyms) from the FED, the government has positively fallen asleep at the switch.  But frankly, Mr. Hovnanian has no one else to blame for his company's current misfortune other than himself and his compatriots, who borrowed too much money to buy too much land at inflated values and built too many houses in what was clearly a bubble (and yes it was very clear to many.)  Now the builders are getting a bunch of tax breaks (Hovnanian received $145 million in a government tax refund in the first quarter) and many of them won't make it DESPITE what has been a ridiculous amount of government intervention to prop up the housing market.  Mr. Hovnanian may complain, but I'm not shedding any tears.       

Citigroup: The $1 Stock That Can't Stay Out of Headlines

It used to be that after a particular stock dropped into the single digits, investors just stopped caring.  The company was delisted from its corresponding exchange and relegated to the indignity of trading on the pink sheets.  Then, maybe seven years later, some headline declaring the company's bankruptcy would hit, you'd scratch your head and say "Hmmm.  Didn't that stock used to trade at $70?  I can't believe it took them this long to go bankrupt." (i.e. Lucent)  So why is it that I pick up the paper every day and have to continue to read about AIG and Citi?   Haven't they done enough damage already to investors and taxpayers' wallets?  The answer, of course, is "yes", but unfortunately the fate of capitalism itself lies in their hands.

The Wall Street Journal brings news of yet another "contingency plan" for Citi, as if three bailouts, the most recent merely a week ago, weren't enough.  According to the Journal, regulators are merely trying to ensure that they are prepared if Citi takes a sudden turn for the worse, which, by the way, they aren't expecting, but, you know, just in case.  Apparently, regulators including the Treasury, the Office of the Comptroller of the Currency, the Federal Reserve, the FDIC and the Post Office (ok, not really, but I hear the Postmaster General was pissed he wasn't included) were involved in discussions with Citi executives over the weekend.  Regulators say that the planning should be seen as a normal function of government during a financial crisis.  Talks of a "bad bank" to take distressed assets resurfaced yet again, as if we hadn't beaten this dead horse to a pulp enough times, but officials were considering other approaches (aka they have no idea what to do other than spout the words "bad bank" every couple of days.)

Citi's beleaguered CEO Vikram Pandit leaked news of actual profitability at Citi for the first two months of the year.  According to the Journal, Citi is having its best quarter in a year and a half, which honestly isn't saying much as the company has puked $40 billion? $50 billion?  Does anyone even keep track anymore?  Apparently, the bank posted revenue - excluding asset write-downs - of $19 billion in January and February.  For the full quarter, earnings before taxes and set-asides for problem loans are $8.3 billion.  Given how many write-downs and set asides for problem loans Citi continues to take, I'm fairly certain that these "profits" are somewhat meaningless.  Honestly, credit spreads are at record wide levels and the bank can finance everything at 0%, so yeah, they're obviously making money financing their inventory.  But who cares if they have $100 billion more in write-downs coming?  That's the only number that matters.  If Citi can have one quarter, just one, where earnings are actually positive DESPITE write-downs and set asides, that $1 stock might start to look pretty tasty.  Otherwise, get back in your $1 hole and stay out of my newspaper. 

FHA-Backed Lenders: Terrible Underwriters

Remember when the FHA was supposed to solve the "credit crunch" by providing much-needed liquidity to borrowers who could no longer get mortgages?  It turns out that FHA-backed lenders are just as bad at mortgage underwriting as the worst of the subprime lenders.  The Washington Post reports that the number of borrowers who failed to make more than a single payment before defaulting on an FHA-backed mortgage nearly tripled, far outpacing the agency's overall growth in new loans.  Industry experts attribute the jump to the weak economy, lax scrutiny of prospective borrowers and most notably, foul play among unscrupulous lenders.  More than 9,200 of the loans insured by the FHA in the past two years have gone into default after no or only one payment.  Of course, the overall default rate on FHA loans is accelerating rapidly too, but not as dramatically as the rate of instant defaults.

But wait, the story only gets better!  The agency's share of the mortgage market is up from 2% three years ago to nearly a third of the mortgages now made.  Under the FHA's rules, if the borrower makes no more than one payment before defaulting there's a presumption of fraud that must be investigated by the lender.  However, the FHA's fraud unit which used to investigate abusive lending practices was dismantled in 2003 as the FHA's business dwindled (presumably it lost business to all of the now-defunct subprime lenders.)  Furthermore, the FHA office responsible for approving new lenders has not expanded despite the fact that the number of active lenders has doubled to 2,300 in the past two years.  Although lenders that are deemed abusive can be kicked out of the program, the FHA does not appear to be adequately staffed to police all of its lenders.  

The article gives a depressing example of a condo project in West Palm Beach, Florida where a 28 unit apartment building was converted to condos three years ago.  The complex had the same owner as an FHA-approved mortgage company that pushed no-money-down, no-closing-cost loans to prospective buyers.  Now, 80% of the loans on the project have defaulted, a dozen after no payment or one.  This particular lender, called Great Country, has the highest default rate of any FHA lender, brace yourself - a default rate of 64%.  Seriously, click on the link if you think that was a typo.  64% of all loans have gone bad!  The article did not mention that Great Country has been kicked out of the FHA program so I'm assuming it is still a lender!  With the FHA taking all of the risk of the mortgage defaults, it's possible to stay in business with that kind of track record.  I, for one, am hoping that Barney Frank reads this article and decides to beef up fraud investigations at the FHA or "Hope For Homeowners" will turn into "Weep the Taxpayers."         

Unemployment Hits 8.1%

The jobs report was as dreadful as expected by those who can still stand to look at economic headlines.  The economy lost 651,000 jobs and the unemployment rate leapt to 8.1%.  Revisions for the prior two months showed losses of an additional 161,000 positions bringing the total number of jobs lost since the recessions began in December 2007 to 4.4 million.  The jobs report is sobering and yet really makes you want to have a drink all at the same time.

Following the lead of other financial institutions looking to retrench, Wells Fargo slashed its dividend in order to save $5 billion annually.  Clearly there is no longer a stigma related to reducing the dividend as investors have begun to prefer the idea of their banking institution actually remaining a going concern over a quarterly dividend check.  JP Morgan and GE made the same announcement recently and I view these actions as prudent, but necessary, if an institution is going to survive the brutal downturn.

Finally, in the "investment bank that needs to finally go away" category, Merrill Lynch is once again in the headlines.  The bank informed regulators that it had discovered discrepancies in certain trading positions.  Conveniently, the losses, which occurred last year, weren't discovered until after Bank of America purchased the investment bank and allowed it to pay out accelerated bonuses.  The details are sketchy so far, but apparently a London currency trader who had recorded a trading profit of $120 million for the fourth quarter, may instead have lost a "large amount."  The Bloomberg story doesn't specify whether we are talking Nick Leeson-large or Jerome Kerviel-large.  At least we have some insight into how Merrill managed to punt $15 billion in the fourth quarter.     

The Good, The Bad and The Ugly

First some reasonably good headline news:

• The ECB cut its interest rates by 50 basis points to 1.5%.  The Bank of England also cut rates to nearly zero and said it will purchase $211 billion in government and corporate bonds.
• Wal-Mart's same-store sales soared by 5.1% last month, besting estimates.  At least consumers are buying something even if it is just bread, milk, bars of gold and guns.
• Jobless claims actually fell by 31,000 to 639,000, although the four-week average rose 2,000 to 641,750.  Continuing claims also slid 14,000 to 5,106,000, which is still very high, but down is better than up.  Brace yourselves for tomorrow's employment report.
• Andrew Cuomo has subpoenaed several Merrill executives who sucked more than $10 million a piece out of the dead carcass before it was handed over to sink Bank of America.  

Some Bad News:

• Barclay's is probably not too thrilled about being asked by Lehman's liquidators to explain what it did with $3.3 billion that was earmarked to pay bonuses and other liabilities when Barclays acquired Lehman's North American investment bank.  Apparently, not all of the money was paid out and the liquidators at Alvarez and Marsal are doing trying their best to recover as much as they can for Lehman's creditors.
• Here's a shocker:  GM's auditors say there is substantial doubt about the automaker's ability to remain a going concern.  
• The difference between the values of loans being carried on the books of our largest banks and the actual fair value of those loans is rather large.  In some cases, if banks were required to mark their loans to market, shareholder's equity would drop below zero.  This gets at the heart of the whole solvency issue of our banks which continues to plague the bank stocks.

And the ugly:

• GE's stock continues its steep decline as the confidence crisis continues.  The credit default swaps on the company's finance arm are trading at highly distressed levels.  Regular readers know that I have been warning about GE's balance sheet since I launched this blog a year ago, in pieces such as "What's Behind the Curtain at GE?" and most recently "Why is GE Still Paying a Dividend?" (not anymore.)  The company relied too much on short-term debt to finance a huge investment portfolio of god knows what (also labeled as "other" on its balance sheet.)  I suppose this kind of accounting used to fly a year ago, but no more.  Investors have woken up, demanded clarity, and want answers.  GE's protestations about everything being peachy are not being met with enthusiasm any longer. 

Financial Headlines 3/4/2009

Some economic headlines:

• US car sales in February fell 41% to a 9.1 million annual rate, the lowest since December 1981, when most Americans rode to work via horse and buggy.  GM reported the steepest decline of 53%, perhaps due to the fact that Americans are forced to endure extreme close-ups of Rick Wagoner's weeping face on the cover of every financial rag. 
• ADP reported that companies cut an estimated 697,000 workers in February.  This report is a precursor to Friday's non-farm payroll report issued by the Labor Department which is clearly bound to be grim.
• Not everyone is suffering due to the collapse of our financial institutions.  The Wall Street Journal reports that 11 top executives from Merrill were paid more than $10 million in cash and stock last year, despite the firms $27.6 billion loss for 2008.  The Journal was even kind enough to name names and post pictures of the top earners.  Merrill's Andrea Orcel took home $33.8 million in cash and stock, which should be more than enough to help cover the increase in security that he's going to need when the angry mob figures out where he lives and shows up for a public stoning.
• 20% of home mortgages were underwater, according to a report released by First American CoreLogic.  Oh wait, forget I said that, just keep paying your mortgage, the government is going to take care of it.
• Out of work in the financial services industry?  Still looking?  Good news!  Public pension funds are hiring, presumably because they need more people to count all the losses piling up from investments in leveraged high risk vehicles such as Morgan Stanley's commercial property "opportunity" fund which is set to take a 60% write-down on the equity in its $8.8 billion fund.  Of course, a $1 trillion bailout for pensions may be just around the corner, so an increase in head count ahead of a large government infusion is highly appropriate.
• According to the Financial Times, AIG has another $12 billion it can punt in credit losses that somehow has not been included in all the many government bailout packages.  But no worries, Bernanke is really mad about having to bail them out, which should make taxpayers feel much better.  

1997 Was a Good Year?

While it's true that Princess Diana died in a tragic car accident and Mother Theresa passed away, 1997 wasn't so bad, right?  The stock market had a good year, well, if you ignore the "crash" that occurred on October 27th, where the Dow plummeted 518 points or 7.18% to 7,161.15 that tripped circuit breakers at the NYSE.  My memory is fuzzy but it had something to do with an Asian financial crisis, not to be confused with the other "crash" in 1998 related to the Long Term Capital/Russian financial crisis.  Of course 1997 was also the year that "Titanic", the highest grossing movie of all time, was released.  Whether you think that was a highlight or not is dependent on the depth of your love for Leo, and whether you had a strong enough stomach to endure Celine Dion's rendition of "My Heart Will Go On" played ad nauseam on the radio.  Maybe 1997 wasn't such a good year after all.

Stock investors are revisiting 1997 whether they like it or not, as the indexes breached 1997 levels yesterday.  Many claim that stocks are dirt cheap, while others argue that the economy is in such dire straits that equity values have much further to fall before they stabilize, much less recover.  I'll admit that its hard to come down on either side of the debate.  Stocks are certainly much cheaper than I have ever seen them in my 17 years following the market.  However, that doesn't mean that they can't or won't get cheaper.  In some sectors (i.e. financials, insurance, homebuilders, or any industry that has significant debt) the equity trade becomes binary.  If the company doesn't go bust in the downturn, then the stock might be a big winner.  Obviously the risks are high, which explains why stocks in those sectors have been beaten to a pulp.  They are either really cheap, or worth zero.  This has become painfully clear to investors that bought stocks in "highly regarded" companies pumped by analyst recommendations (AIG, LEH, MER, BAC, WB, WM etc) this past year that have lost over 95% of their value.  

At some point, getting hit over the head with a stick over and over again leads to a change in behavior.  When the average investor gets tired and leaves the market, all you have left are people like K10, who like to take risk.  I understand what most of the risks are, including the fact that I definitely don't know all of the risks, but I still like to show up to play anyway.  Not everyone enjoys this style of investing (aka "trading") and many will throw in the towel which should lead to capitulation.  I'm still waiting for capitulation before placing a longer term bet on equities.  I have no idea when or how it will happen, but I suspect I'll know it when I see it.  

AIG: $61 Billion Loss, New Bailout

AIG reported a net loss of $61.7 billion in the fourth quarter of 2008 which brought 2008 losses to $99 billion.  I'll give you a moment to digest that information before moving on.  Once you stop crying we can discuss the breakdown of the losses, which are actually sort of funny because they come from pretty much every single department.  For those interested in the gory details, AIG breaks out the losses in a handy table here.  Highlights include $25.9 billion in "market-disruption related adjustments" (aka "bad investment decisions we made",) $21 billion from tax benefits not obtained for losses incurred during the quarter (aka "we no longer pay taxes as we only suck money out of the government") and $6.9 billion related to the Fed credit line (aka "at least the Fed makes us pay for bleeding the Treasury dry.")

The "good news" is that AIG will get yet another $30 billion in new government capital and the government will convert its existing $40 billion of preferred shares into new preferred shares that more closely resemble common stock (i.e. they don't get a dividend and are worthless.)  Under the new terms, the Treasury is to get a 77.9% equity interest via preferred stock on Wednesday.  The Fed will take up to a $26 billion preferred interest in two AIG life insurance subs as well as make $8.5 billion in new loans to benefit the domestic life insurance subs of AIG.  Additionally, the interest rate on the existing credit facility will be modified to reduce the existing floor.  If you don't understand the finer points of the new government bailout, don't worry.  I admit I haven't spent significant time analyzing it either.  But I get the big picture which hasn't really changed in the past year.  AIG took too much risk and blew out.  The government is just trying to unwind the business with the least amount of disruption to the market and economy.