FHA Reserves Below Minimum

The FHA's capital-reserve fund fell to $3.6 billion as of September 30th, leaving reserves at just 0.53% of the $685 billion in total loans insured by the FHA. This is far below the 2% requirement level that the FHA said it had breached months ago. The Secretary of HUD, Shaun Donovan, downplayed the FHA's problems and claims that the FHA won't need a federal subsidy except under the most severe economic scenarios. Like 10% unemployment, maybe? The problem is that projected capital losses in 2009 were worse than the most pessimistic assumptions from last year's review, so really, I'm not sure we should trust Mr. Donovan's reassurances of the agency's solvency.

Apparently, this is what happens when the government tries to prop up a mortgage market that was initially propelled aloft by private no-downpayment mortgages to people with terrible credit. While FHA-insured mortgages require small downpayments, they are still offered to borrowers with lousy credit. The only difference between FHAs and Alt-As is that FHA mortgages have very low fixed rate mortgages, so there is no surprise doubling or tripling of payments a few years down the road. Unfortunately, default rates on FHA insured mortgages are surging, proving that minimal downpayment mortgages to borrowers with terrible credit are extremely high risk, even with a fixed rate. The '08 vintage already has a 15% delinquency rate, handily outpacing earlier years' vintages. Furthermore, the volume of loans insured by the FHA jumped 75% in the 2009 fiscal year to more than a quarter of the mortgage market, from a mere 2% in 2006. During the second quarter the FHA backed nearly half of all mortgages made to first-time home buyers. No matter how much HUD tries to downplay it, it is inevitable that we will be bailing out the FHA too. So, sure the housing market is stabilizing. But at what cost to the rest of us?

UBS Still a Mess, AIG Ditto

UBS, Europe's poster-child for the most egregious financial and ethical performance during the credit crisis, has announced that it will raise $3.5 billion in a share sale and post yet another loss. The bank sold shares to a "small number of institutional investors" that somehow still think that this pig is a good investment. I'm not sure how many more billions the bank has to punt in order to finally discourage supposedly savvy investors from throwing good money after bad, but some folks just never give up. Even the recently highly optimistic Bloomberg can't think of anything more positive to say than "UBS decided to raise the funds to bolster confidence in the bank following record losses, client defections and a US probe into possible tax evasion by wealthy clients." Given that the noose has been pulled around UBS's tax evading neck, it's hard to imagine more clients aren't going to flee. I mean if you can't get a good tax shelter out of these guys anymore, what good is their money management advice? If they really know how to make money, don't you think their investment bank would stop pissing it away?

AIG will hold its annual meeting on Tuesday, its first with the US government as the controlling shareholder, and it should be a doozy or more likely a snoozefest. Among those expected to be in attendance are the three trustees who are overseeing the 80% government ownership of AIG and their six handpicked candidates who will form the majority on the new 11-member board. If you plan to attend, make sure to bring extra coffee. Meanwhile, the Fed announced a deal yesterday with AIG where it would swap $25 billion in debt for stakes in two of AIG's foreign life insurance units, leaving the beleaguered insurance firm with only $18 billion in debt with the Fed, chump change compared to the $84 billion the Treasury has plowed into the firm. Once again, the company is finagling out of paying interest on debt and swapping it into an equity stake in units whose values are ambiguous. If they were really worth $25 billion, or even more, than the company should just sell them to a private investor or hold an IPO to repay the Fed directly. AIG claims that it plans to IPO the units and that the Fed will get the first dollars from those sales, but it could take a significant amount of time before the Fed gets its money back, if it ever gets its money back. How we keep getting roped into giving AIG better and better deals I'll never understand. But then I've had a very hard time swallowing the leniency the government has shown to our financial institutions that were largely responsible for the financial meltdown.

Who Financed Goldman's Record Bonuses?

The Guardian published a much-ballyhooed article this weekend about a Goldman Sachs staff meeting in London where employees were told that they could look forward to record bonuses if the company registers its most profitable year ever. The bank, which repaid its TARP funds last week is rumored to have had a record first half, although it has yet to complete its second quarter and report results. Before everybody gets out their pitchforks, a moment of rational reflection is in order. First of all, whatever boob in attendance at the staff meeting that actually leaked this news to the press, amidst a worldwide recession where the finance industry's excesses have launched a political firestorm, should be canned. Once that's out of the way, we can talk about what exactly is wrong with the picture.

First of all, it helps to analyze how it is exactly that Goldman Sachs has managed to make so much money. The folks at GS are savvy traders, no doubt. But the real answer is that a host of government subsidies kept the investment bank alive during some of the most nauseating turbulence in the credit market's history. The $10 billion in TARP funds was chump change compared to the trillions in liquidity for illiquid assets that the Fed added to the market last year via its new lending facilities (TSLF, TAF, PDCF etc etc.) By taking over the roll of financing illiquid assets, when the Fed lowered interest rates to zero, it essentially reduced the cost of funds on ALL collateral to zero, not just treasuries, thus boosting profits substantially for the banking system. Meanwhile, spreads on illiquid products continued to trade at historical wides, which, as long as I've been in the market, has been unprecedented during an easing cycle. Furthermore, the Fed bailed out AIG, which meant that GS actually got to collect on its margin calls directly from the Fed. Although GS has made repeated claims that it was properly hedged and would not have had material exposure had AIG failed, I'm not buying that claim. Sure, Goldman might have hedged, but where did it get its hedges? Would those counterparties have survived a failure of AIG and would GS have been able to collect from them without a government guarantee? Last, but not least, GS was allowed to issue billions in FDIC-guaranteed debt at a greatly reduced cost from where its debt was trading at the time. One thing's for sure, if GS is paying record bonuses, that means at least our deposit insurance fund is safe for another year or so.

The Goldman record-bonus story illustrates precisely the flawed thinking behind Paulson and Bernanke's notion that if you bailout the financial sector, you bailout the economy. The economy is still struggling mightily. If it weren't for Fannie and Freddie, that are now direct wards of the government, it would be impossible for consumers to get a loan of any kind. As it is, the financial press is filled with reports of consumers and businesses getting cut off from credit. Yet Goldman Sachs made boatloads of money trading commodities, currencies, and fixed income. What the government did instead of boosting lending to the economy, was subsidize Goldman's, and in fairness, the other banks' trading operations, so they could go on to pay bankers a bunch of money. When populist furor initially erupted, those "in the know" kept saying that the average American didn't understand how finance really works and that they were too stupid to get why it was important to bailout the banks. But couple the Guardian article with the one in today's FT entitled "Bankers' pay soars as struggling groups aim to halt talent exodus," maybe the American public understood the picture after all.

Supreme Court Delays Chrysler Sale to Fiat

The quick and tidy sale of Chrysler to Fiat has been delayed by at least one day while the Supreme Court decides whether to hear an appeal of the deal.  Secured creditors were understandably pissed off at the raw deal they were handed during the government-led restructuring plan.  I'm no legal expert, but the whole idea of changing the order of priority in bankruptcy by handing unsecured creditors a big piece of the pie before secured creditors are paid out is not just wrong, but is a threat to the integrity of our financial markets.  Markets have rules for a reason.  If you interfere and change the rules too much, at some point nobody is going to want to show up to play anymore.  No telling what the Supreme Court does next.  They could just allow the stay to expire, in which case, Chrysler's sale to Fiat goes through.  Or alternatively, the Supreme could hear the appeal, Fiat could walk away, which would lead to a Chapter 7 style liquidation.  I don't know about you, but I'm sitting on pins and needles.     

Government Hires a Pay Czar

JP Morgan and Goldman Sachs are anxiously drumming on their desks, checking their watches, waiting to be given the all clear to pay back all that government money they never wanted (or needed, mind you) in the first place.  They don't like it when government officials, with their lowly six figure salaries, tell them they can't pay their 25 year-old traders $6 million dollars if they feel like it.  They figure, if they can just get out from under this albatross, they can get back to business as usual (parties, chicks, private jets, golf boondoggles.)  The only problem is, even if they pay all the TARP funds back, it appears as if they're going to be subject to tighter compensation scrutiny anyway.  The Obama administration will be issuing broad principles and standards on compensation that the government would like the financial industry to observe.  The details are murky at this point, but there is little doubt that the government's take on financial industry comp will be interesting to say the least.  Those institutions receiving at least two federal bailouts will be required to submit any major executive pay changes for approval by the new Pay Czar.  I wonder what will happen to all of the recent announcements by banks that they will be doubling and tripling salaries?  Wonder how the Pay Czar is going to feel about that maneuver?  If I were the Pay Czar, my first move would be to ban the use of compensation consultants by boards as I believe they have been instrumental in jacking up the absurd executive compensation packages linked to no performance that we've seen in corporate America in recent years.  Because seriously, why can't boards figure out how to compensate their companies' employees without having to pay someone to tell them?  It seems like corporate boards have done little to root out fraud, or notice that management was taking too much risk, is it too much to ask that they get a spine and get involved in appropriately compensating executives?  Apparently, which is why we now have a Pay Czar.

The most curious part of the New York Tines article is the following sentence: "Banks that received money from the relief program must also curb outsize severance packages, and pull back bonuses that were based on fraudulent or misstated results."  Now, I'm sure that part of this is in reference to the Wall Street Journal report a few days ago about Citibank halting severance payments to five former employees to whom it had promised over $100 million when they left a year ago.  But, does it mean that the government can go after bonuses that were paid in 2007 that were based on unrealized profits that turned negative in 2008?  Can the government then clawback any money it paid to the AIG financial products unit where the "earnings" were a complete mirage for years?  If so, things are about to get really interesting. 

Bank Capital Raising Frenzy Continues

On the heels of its $8 billion capital raise last month, Morgan Stanley, perhaps stunned by how high its stock price has remained, is raising another $2.2 billion in equity. Gotta pay back that TARP so it can return to paying bonuses at the expense of shareholders. Interesting that shareholders are still willing to buy into that philosophy. Yesterday afternoon, JP Morgan and American Express both announced plans to raise more capital. This is the first time to the trough for JP Morgan, which is raising $5 billion. Meanwhile, AmEx raised a more modest $500 million yesterday.

If you don’t believe that paying back the TARP is primarily a compensation issue, then just check out Citi’s announcement today. The beleaguered bank is halting severance payments to five former executives that left last year. According to the WSJ article, Citi had promised roughly $100 million in payouts to these executives, and has already made roughly half of the payments but is halting the rest. The bank is betting that the executives will be too embarrassed to file lawsuits, as evidenced by the outrage caused by the AIG payouts. For evidence that Wall Street’s ideas about paying “talent” ridiculous sums of money for seemingly no reason, I present you with exhibit A: Michael Klein. Mr. Klein, a 23 year veteran of Citigroup, was the head of investment banking. He RESIGNED in last July. Funny thing is, I have resigned from a few jobs in my time, and I’ve never been granted severance. Severance is for people who are laid off, not those who resign. Despite this, Citi offered to pay Mr. Klein a “severance” of $42 million in return for not poaching any of the bank’s investment bankers. I know that Citi is on a huge cost cutting scheme, reducing the amount of money it spends on paper clips and copies, etc. But $42 million buys a lot of paper clips. Why on earth the bank, which is suffering from some serious financial problems, felt obligated to pay someone this kind of money when he was leaving the firm and would no longer contribute one iota of value to Citi, shows a complete and total lack of economic prioritizing. Citi knows that this kind of wanton flushing of money down the toilet no longer flies as it has no shot in paying back the government any time soon. The rest of the 19 banks don’t want to be subject to the same constraints next time they feel like paying someone $42 million for no good reason.

As I’ve noted before, I want the banks to pay back the TARP. I don’t think taxpayer money should be funding risk-taking. I don’t care what banks pay their employees, but I don’t think the government should subsidize outrageous Wall Street style compensation, especially when the unemployment rate is 9%. But my conditions for TARP repayment are the following: You pay back the TARP, and this whole government-backing-the -banks scheme is over. Going forward, no more TARP, no more FDIC guarantees, and no more pledging any collateral other than treasuries to the Fed for loans. No more Too Big To Fail. The government shouldn’t be bailing out risk takers.

GM Set to File Chapter 11, Chrysler Set to Exit

In the most predictable event in bankruptcy history, GM is finally filing for Chapter 11 this morning. Uncle Sam will wind up owning a majority of the company with plans to inject another $30 billion in order to keep operations going while the creditors hammer out the details during the bankruptcy process. The US government will receive a 60% stake for its investment, while the Canadian government will inject $9.5 billion in return for a 12% stake. GM plans to eliminate all of its debt, halve its brands, shutter 2600 dealerships (out of 3600) and rewrite its labor contracts with its 56,000 employees. The bankruptcy process is expected to be swift, although complications may arise.

In a nice demonstration of tag-team, Chrysler is scheduled to emerge from bankruptcy as early as today, just one month after its filing. The administration managed to show all the naysayers that a quick bankruptcy for Chrysler was possible. Who knew that a little political jockeying, and the liberal sprinkling of TARP funds among lenders, would convince secured creditors to accept less than unsecured creditors in a bankruptcy? But it seems like the rules are rewritten every day when the government has a hand in the capital markets.

Although the long run consequences of the downsizing of the US auto industry are unknown, there is no doubt that having a streamlined, yet financially viable auto industry is preferable to the bloated uncompetitive mess we had before. The only problem is that the adjustment period is bound to be very difficult for the many whose livelihoods depended on a huge, bloated, inefficient auto industry. It’s not just the dealerships that have been forced to close, or the employees whose compensation and benefits will be slashed, not to mention those who will surely lose their jobs. What about the auto parts makers (some of whom are filing for bankruptcy too?) The advertising industry that relied on copious purchases of air time on TV and radio? Or the local economies that will suffer greatly as factories are shuttered and the tax base is eroded? Sure the easy part, (i.e. drafting the financial plan), might be behind us. But the hard part, that of filling the huge hole in the economy that the slimmer auto industry leaves in its wake, well that part lays ahead. That’s the part that concerns me the most.

BankUnited Seized By FDIC, Private Equity Consortium Gets Sweet Deal

BankUnited, the largest independent bank in Florida that specialized in that low-risk business of lending money to foreigners so they could buy properties in Florida during the housing bubble, was finally laid to rest by the FDIC. The FDIC has been looking for a buyer for the beleaguered bank for months, and conducted its auction yesterday. Although the FDIC was hoping to find a legitimate buyer, no bidders emerged that were willing to acquire the failing financial institution without massive loss guarantees. The winning bidder of the carcass of BankUnited was a consortium of private equity investors including Blackstone, Carlyle, Centerbridge and WLRoss yesterday. With assets of nearly $13 billion, BankUnited is the 34th and largest bank failure of the year, and is second only in size to IndyMac’s colossal failure last year.

On the surface, it should seem like a huge relief that the FDIC found a buyer for this large banking dud. That would certainly seem to be the case if the private equity buyers weren’t getting a ridiculously sweet loss guarantee from the US government. The government will take 80% of the first $4 billion in losses and 95% of any remaining losses. The next time I make any investment decision I’m calling the FDIC to see if I can arrange some sort of guarantee where the federal government eats around 90% of my losses, leaving my only risk to be that I break-even instead of make a mint. Oh sure, the FDIC will receive warrants giving it a share of any future upside, but the details on how much it will receive are scant, and it can’t possibly make up for the fact that the government is taking nearly ALL of the downside. Yes, the private equity firms are putting $900 million of equity into the bank and relieving the FDIC from the burden of having to wind down another large bank, but really, is all of that worth $10.7 billion in potential losses?? Seriously, why is the FDIC giving massive loss guarantees to private equity firms? Somehow this arrangement is still billed as a private sector deal with the FDIC claiming that the deal “is projected to maximize returns on covered assets by keeping them in the private sector.” But the truth is that, once again, only the profits go to the private sector, our rapidly dwindling deposit insurance fund gets to eat the losses. It’s “heads I win, tails you lose” all over again. Sadly, this is what our private sector is evolving into, only if you are a well-funded, politically connected finance firm, of course. The FDIC never called me to ask if I wanted to bid and I definitely would’ve tossed my hat into the ring with terms like these. At least the FDIC was approved on Wednesday to borrow $100 billion from the Treasury if it has a shortfall in its insurance fund. That piece of legislation couldn’t have been signed into law soon enough.

Continuing Claims Continue Rising and Other News

While new jobless claims fell to 631,000, continuing claims rose yet again to 6.7 million, another record. More grim employment data.

In government bailout news, GMAC will receive a cash infusion of $7 billion, part of a package that could reach $14 billion. If you’re in the car business, which the government finds itself knee-deep in, you have to have a way to provide financing to your remaining dealers, as well as to the consumers who are supposed to buy your cars. The government needs some version of GMAC, and GMAC won’t make it without more financial help. So, now we own GMAC too. Sigh.

In depressing global economic headlines, the WSJ has a very nice chart displaying how poorly the US’s main trading partners around the world are faring. Mexico’s GDP contracted by 21.5% on an annualized basis, while Japan’s fell 15.2%, and Germany’s declined an abysmal 14.4%. These steep declines are mostly our fault, as US consumers have scaled back purchases of foreign goods due to our own economic contraction. The US’s milder yet not-insignificant 6.3% contraction shows that maybe it’s not the worst thing in the world being a net-importer of goods. We can just stop buying foreign stuff, but our trade partners who depend on us buying their stuff are suffering far worse economic fates.

Finally, in more “at least we’re not doing as poorly as they are” news, S&P lowered its outlook on the UK’s debt. The rating agency warned that the country must get its finances in order or risk losing its triple-A rating on its debt. Predictably, the FTSE and pound took a tumble. With the way the US spending coupled with the sharp decline in tax receipts, it’s hard to imagine we’re too far behind.

Small Banks Vs. Big Banks

The Wall Street Journal did a study of 940 smaller banks and concluded that commercial real estate loans could generate losses of $100 billion by the end of next year. The WSJ’s analysis used the loan-loss criteria that the Fed used in its stress tests of the largest banks. The Financial Times did a similar analysis recently. There is nothing new or shocking about this analysis. The high likelihood of many small bank failures due to commercial real estate exposure has been floating around in the news for some time.

The FDIC, the government entity charged with seizing failed banking institutions is at least attempting to be proactive. It is weighing levying a one-time fee to replenish the agency’s deposit insurance fund that would hit big banks harder than small banks. The deposit insurance fund has been whittled down to $19 billion at the end of 2008, but there have been around 25 bank failures already this year, so clearly, the agency will run out of moola if it doesn’t do something soon. The new proposed fee is to be $.05 for every $100 of assets after deducting certain capital holdings. In February the FDIC had proposed a $.20 fee for every $100 of deposits, but smaller banks didn’t like this proposal because they felt they were being unduly punished for the financial crisis, which they contend was primarily caused by the big banks. Executives at the big banks counter that almost all of the banks that have failed in the past 18 months have been small institutions. I’m curious which large bank executive the WSJ interviewed to get that quote and could he have possibly said it with a straight face? Was it Vikram Pandit? Ken Lewis? Can you possibly make such a ridiculous assertion after your institution has received multiple billions in direct capital infusions, the ability to issue government guaranteed debt, and the ability to finance ANY collateral including equities via the Fed? Sure most of the banks that have failed have been small, but that’s only because the government has absolutely no mechanism for seizing large banks and chose to prop them up indefinitely instead.

Meanwhile, the folks at Goldman Sachs, JPMorgan Chase, American Express and Morgan Stanley are itching to repay the TARP. The authorities have decided to allow a group of banks to return the funds rather than approving individual applications to avoid a “rush to the exits,” whatever that means. I’m all for banks repaying the TARP. I never wanted government money involved in our banking system to begin with. Here’s the deal, though, they shouldn’t ever get the money back for any reason. Ever. The government should make it clear. Next time you are on the brink, we’re going to allow you to fail. Period. And if the government doesn’t have a mechanism in place to deal with a large institution’s failure, then it’s too soon to allow them to pay the money back.

Stress Tests Weren't Tests At All

Remember back in high school when you failed that test?  Then you went to your teacher and tried to explain to him why it would be really bad for your social life if you went home with an F and how you sort of wanted to go to the prom?  Then your teacher just changed the grade to a B+ and sent you on your way?  Wait a minute.  That never happened to you?  You mean you never got to renegotiate the results of any test you ever failed in high school?  That's too bad because your teacher missed out on a great opportunity to teach you a very important real life lesson.  Because in the real world, if you're a bank that lost multiple billions on lousy bets on the market, and you did it in such a large way as to pose a systemic risk to the global economy and to require a government infusion of taxpayer dollars, and your regulator tells you that you need to raise X amount of capital, you can argue until you get a better deal.

If you thought the stress tests were rigorous and would reveal the true financial situation of the nation's largest banks, think again.  According to the WSJ, when banks were presented with the initial results of the stress tests, they fought back and the government conceded and adjusted the amount of capital downward, in some cases by a significant amount (see Bank of America that was originally ordered to raise over $50 billion.)  Furthermore, according to the FT, instead of needing to raise the full revised-down $75 billion, banks will now be able to meet their capital raise through "earnings" over the course of the next six months.  With the relaxation in mark to market rules, a zero overnight lending rate (the benefit of which banks don't need to pass on to consumers), and the government's generous support of the credit markets through its variety of programs, drumming up some earnings should be a snap.  Problem solved.  Banking system saved.

The problem now is dealing with the economy.  Friday's unemployment report was grim.  Sure, it was "better than expected" but once revisions were added and the temporary census workers subtracted, the economy lost around another 700,000 jobs.  Even if you ignore the revisions and the census workers, since when has losing 539,000 jobs in a month been considered incredibly bullish?  If this is a green shoot, then, well, shoot me.  Because we still have the fallout from the auto industry, the retail industry, and the commercial real estate market to deal with.  When we've figured out what industry exactly is going to pick up the slack for those we've lost, I might consider being an optimist again.  

   

Stress Test Results Revealed, Finally

The stress test results are finally official. No more beating around the bush. No more mysterious leaks to the press. The Fed is requiring 10 out of 19 banks to raise a total of $75 billion to cover capital shortfalls in the event that the “worst case scenario” for the economy becomes a reality. Whether the Fed’s interpretation of the worst case scenario for the economy turns out to be as bad as the actual economic performance of the economy is an entirely different question. Given that the Fed never thought there was a housing bubble, thought the subprime crisis was contained and sort of missed the whole credit crisis until banks were coming apart at the seams questions its ability to forecast a worst case that’s even in the ballpark. Nevertheless, just keep buying bank stocks. Everybody’s doing it.

The Fed is forecasting losses of up to $600 billion for banks through the end of the year. $600 billion sounds fairly ominous and worst-case-ish, but there are estimates in the trillions floating around, so only time will tell what the final tally will be. Bank stocks have rallied so powerfully since the March 6 low that raising capital right now doesn’t appear nearly as daunting. Already, Wells Fargo and Morgan Stanley have announced common equity offerings. It’s best not to dilly dally as there’s no telling if and when sentiment turns again and bank stocks take another drubbing. What to do if you’re GMAC and you’re privately owned by GM (on government-funded life support) and Cerberus (worst private equity investor of all time) and the government just told you to raise $11.5 billion? Maybe GMAC will give its bankers a call. I hear they just raised a slug of new capital they need to put to work.

More Stress Test Result Leaks

Bank of America faces a $34 billion gap in its capital as a result of the government stress test, according to the “person familiar with the situation” that is responsible for leaking news to the WSJ. $35 billion is a fairly large nut, it is equal to roughly half of the bank’s current stock market value. It seems unlikely that B of A can raise this amount of money in time by selling assets or more shares to the public, although it is reported in the FT today that it is weighing a sale of its $8 billion stake in China Construction Bank. Conveniently, the lock-in period expires tomorrow, the day the stress test results are officially released, so perhaps the beleaguered bank can announce the sale of its CCB stake side-by-side with the results of the test. Bank of America will more than likely need to convert the government’s preferred shares into common equity to satisfy the shortfall, leaving the government with a large stake, and diluting current shareholders. The stock is up around 5% on the news premarket.

Once the actual results are released, they will likely prove to be anti-climactic and investors will have to return to paying attention to mundane things like earnings and economic data. I’m not sure what Mr. Stress Test Leaker will do with all of his newfound spare time.

How Long Can the Bank Rally Last?

As the stress test results continue to be leaked slowly, the news out today increases the total number of banks that reportedly need capital to 10 out of the 19. Since bank stocks absolutely ripped on the incredibly bullish news yesterday that 4 banks may need capital, the S&P is bound to hit 1450 today. The most reasonable explanation I could find for the return of enthusiasm for owning bank stocks is the belief that banks can easily raise the capital they need and everyone can go about their merry way making money again by lending at some interest rate, any rate will do because it is bound to be higher than zero, their financing cost. What I’ve had trouble reconciling though, is that a number of fairly intelligent people believe that roughly $4 trillion in toxic assets still sit on banks balance sheets. Furthermore, even though everyone keeps emphasizing the “green shoots” in the economic data, I’m having trouble figuring out what on earth they are talking about. Both pending home sales and construction were up slightly yesterday from abysmal levels and the headlines beamed “great housing news boosts stocks!”

But maybe I’m just too pessimistic. Spreads in credit markets have tightened considerably since early March. Investor interest is picking up in the Fed’s TALF program, which had $10 billion in demand this month, the highest since the program was launched. Certainly these are positive signs. But then I remember what a looming disaster the commercial real estate market is facing, and how that is bound to whack bank stocks further. Then I wonder what the employment report will look like Friday, and I think that maybe the market has just gotten ahead of itself. After all, wasn’t it a year ago when the heads of certain banks that have since received significant government infusions or are now unemployed were claiming with confidence that the worst was over? How long can the bank stock rally last? Longer than any short worth his salt can stay solvent.

Citi, B of A Argue Stress Test Results

Citi and Bank of America are not happy with the results of the government-mandated stress tests, which will force them to raise significant amounts of new capital. According to the FT, Citi needs $10 billion more, while B of A needs “well in excess of $10 billion.” The banks are furiously arguing their case, claiming the stress test results were too pessimistic. PNC and Wells are also mentioned as regional lenders that would be required to raise capital, unless they manage to convince the Feds otherwise.

In the event that the government prevails, Citi is rooting around for more securities it has issued that can be converted into equity. The good news, for Citigroup at least but not so much for investors that were hoping to continue to collect interest on their trust preferreds, is that Citi has around $15 billion in trust preferred securities lying around that it can convert. No word yet on how B of A plans to fill its hole.

Stress test results have been delayed and will be released on Thursday, May 7th giving the market plenty of time to continue rallying for no good reason. Somebody wake me up if anything interesting happens before then.

It's Official: Chrysler Files Chapter 11

Sometimes it’s fruitless to read the articles until the real deal hits the tape. No amount of frenzied negotiation by the government could cement a deal between Chrysler and the holders of its bank debt, some of whom seemed to believe they were getting the shaft relative to the unions. So Chrysler is going to court and will have this whole messy business wrapped up in a jiffy, 30-60 days according to the President, which seems hard to believe.

Despite its loss of market share over the years, Chrysler still employs over 50,000, many of whom will certainly lose their jobs. Additionally, dealerships will be forced to close, as the automaker has fewer brands to sell. Although a newly restructured company is necessary and healthy, the interim will be painful, particularly since the rest of the economy stinks. What are all those former employees and out of business dealerships supposed to do now? Go make or sell GM’s crappy cars?

In any event, there are two bright spots out of all of this. First of all, the clowns at Cerberus will have their entire equity investment wiped out, proving that no amount of financial wizardry or political clout can save a really stupid investment. Maybe they’ll think twice before piling a bunch of debt onto a company in a highly cyclical industry six years into a boom. Hopefully, they won’t ever get the opportunity again. Second of all, Bob Nardelli, Cerberus’ choice to lead Chrysler directly into bankruptcy, finally proved definitively that he was the most overrated CEO hire in the history of the US corporation. What kind of a tool leaves a company (Home Depot, where he worked prior to his gig at Chrysler) in a huff because he refuses to take a pay cut off of his ridiculous $200 million pay package, despite the company’s lackluster performance during his leadership? This was Mr. Nardelli’s shot to prove that he was worth all that money and Home Depot made a mistake by forcing him out. Turns out, he was just grossly overpaid.

GM Bondholders, BAC, C Shareholders – Not Happy With Government

Not surprisingly, GM’s unsecured bondholders weren’t pleased with the offer from the government of 10% equity plus zero cash, particularly since the UAW would wind up with 39% of equity plus 50% cash recovery. Bondholders are preparing a counteroffer, one that perhaps involves meeting everyone in a bankruptcy courtroom.

Meanwhile, in top leaked news, Bank of America and Citigroup may be required to raise more capital according to “people familiar with the situation.” I’ll never understand why people familiar with the situation felt it was wise to leak the news a week before the results of the stress tests were due, but I suspect it may just be someone who has a bone to pick with Ken Lewis, who is already facing a world of hurt from angry shareholders for not informing them in December that Bank of America was about to pay far too much for Merrill Lynch’s pile of garbage. Everyone knew Citi would need more capital, but Bank of America was perhaps tougher call. Both banks will contest the government’s findings, but this could mark the end of the road for Mr. Lewis’s career at B of A. Prepare yourselves for more leaks about other banks’ conditions in the next week. While the government may not want you to think that the need to raise capital is a sign of insolvency, it’s hard to take the news in any other way.

Admistration Talks Tough on Banks, Sort of, Maybe

The Financial Times headline reads "US Prepared to Oust Bank Chiefs." Tim Geithner warned on Sunday that the US government would consider ousting board members at banks as a condition for giving the institutions "exceptional" assistance in the future. He neglected to define "exceptional," but given the size of the bailouts we've seen so far with nary a banking executive ousting, I'm going to assume it as greater than $150 billion.

Meanwhile, the administration's PPIP (aka "Pay a Premium for Investment Pukeage," I'll be accepting suggestions for better definitons that fit the acronym) gave a much needed boost to the equity markets in the past few weeks, as many theorized that this would dramatically alleviate the toxic asset problem that our banks face. In contrast to the tough talk that the Financial Times highlighted in its article, the PPIP is a huge gift to the banks and private investors. Sort of. The government will subsidize higher bids for toxic assets because it is assuming all the risk, while private investors participate principally on the upside as they are required to put up very little capital. The PPIP is similar to the zero down payment, no-doc mortgage loan with a teaser rate. Why would a home owner not overpay for a house if the bank takes all the downside when housing prices decline? The government is attempting to solve one problem by making exactly the same mistake. Again. Except this time with taxpayer funds.

On the other hand, FASB relaxed mark to market rules for banks allowing them significant discretion in valuing their portfolios. As many an astute commentator has pointed out already, allowing banks to make up their own valuations for assets "solves" alot of their problems. For one thing, earnings miraculously improve. For another, banks don't have to sell any assets at the market price if they can just mark them at higher prices and "improve" capital positions that way. The FASB accounting change actually discourages banks from participating in PPIP. Maybe FASB and the Treasury should've gotten together and coordinated on this issue? Mr. Geither has continued to dodge the crucial questions as to whether banks will be forced to participate in the PPIP, or even be required to use the market prices that the PPIP produces.

The $1 (or $3?) trillion question, despite the administrations efforts to goose lending , remains the same; will default rates rise to equal the catastrophic levels currently reflected in the market prices of toxic assets? Mike Mayo, a noted analyst, released a report this morning claiming that default rates will exceed depression era levels. If he is right, no amount of government guarantees or accounting chicanery can help the banking sector.

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.      

 

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?