Treasury To Capitalize Banks By End of October, Then What?

Reuters claims that the Treasury Department plans to start directly injecting capital into US banks in the form of preferred shares as early as the end of October.  Reuters is citing a source "familiar with Treasury Secretary Hank Paulson's thinking."  The Treasury is aiming to follow the lead of the British government which pledged $87 billion in capital to its own banks in return for preferred shares.  According to this "source familiar with Paulson's thinking", the Treasury is working extremely fast to put together the capital injection plan.  On one hand, it may be advantageous to get this plan underway, I don't know, perhaps tomorrow, as the market is acting suspiciously as if it might pull one of its famous Black Fridays.  On the other hand, bank stocks get cheaper every day so it behooves the Treasury Secretary to wait to get a better deal.  No word from "the source" on whether the US plans to guarantee interbank lending, which is the next extraordinarily drastic action the Fed is likely to take.  Although I'm not intimately familiar with Mr. Paulson's thinking, I suspect if these two actions fail to restore calm to the capital markets he may turn to his buddy Mr. Bernanke and say "Fine!  You win.  Cue the helicopters!"

Some banks may choose to bypass the Treasury and raise capital in more ingenious ways.  Having missed the brief opportunity to issue equity when its stock was in the 20's while the short sale ban was firmly in place, Citi got distracted by its battle with Wells Fargo over Wachovia.  Citi has thrown in the towel and let Wells Fargo walk away with the prize.  Of course while Citi dilly-dallied, its stock was cut in half, so an equity issuance at this price is not particularly appealing.  After witnessing the bludgeoning of Bank of America's stock as it struggled to raise $10 billion, Citi is looking for another way to shore up its balance sheet.  So, it is taking the low road and suing Wells Fargo and Wachovia for $60 billion.  In times like these, an extra $60 billion could come in really handy.

A lack of confidence continues to permeate throughout the capital markets.  Banks aren't lending because of legitimate counterparty risk fears (see Iceland's implosion.)  Shares in Morgan Stanley have received a drubbing based on who knows what?  Rumors are circulating that the Mitsubishi investment may not go through and that the investment bank may not make it (CDS in MS are trading at distressed levels and the stock continues to come under attack every day, reminiscent of Lehman and Bear.)  Furthermore, insurance stocks have fallen off of a cliff in the past two weeks as investors become concerned about the fixed income assets on their books.  But hey, it's just a continuation of the financial beatdown due to frozen lending markets, yada yada yada.  Why were stocks like Exxon and Chevron down nearly 10% apiece while crude was only down 5%?  I suspect it was related to  hedge fund liquidations.  The long commodities/short financials trade was very popular with hedge funds this year and seemed to be the only money making game in town for awhile.  However, in the past month the commodity sector has gotten drilled due to fears of a global economic recession and hedge funds have suffered large losses.  Hedge fund redemptions have soared as investors have grown increasingly nervous about taking risk, forcing these leveraged players to liquidate.  As a consequence, many of the big momentum names from this year have suffered extraordinary losses just in the past month (POT, MOS, FCX, just to name a few.)  

What's an investor to do?  Due to my options trading background, I like to look to the VIX, which surpassed 60 today, an indicator that is flashing "PANIC PANIC PANIC!"  When the short-sale ban was originally announced, I put up several posts castigating the SEC for attempting to manipulate stocks higher.  I predicted that smart financial institutions would issue equity during this period (which they did) and that the market would crash after the short-sale ban expired.  Instead, stocks cratered while the short ban was in place after the initial pop on expiration Friday when financial stocks surged to absurd levels (Wachovia at $24?  Washington Mutual at $5, neither of these institutions made it, by the way.  Thanks Chris Cox, you've been very helpful.)  Stocks continued to crater today as the short-sale ban expired.  I crawled into my bunker a few weeks ago when the short-sale ban was enacted and asked that someone call me when the VIX hit 60 and so it has.  While I'm certainly not going to call the bottom, I will say this:  If tomorrow really is a Black Friday, it may be worth it to anyone with a strong stomach to buy a few shares of stock in the panic.  I'm not recommending that investors do this, I'm just saying that I probably will.

My regular readers should understand that this is a fairly bold pronouncement from a curmudgeon who has been consistently and unwaveringly bearish on the market since I began this blog (and for some time before.)  Unlike most of the equity investment and pundit community (yes that includes you, Jim Cramer) who have called the bottom over and over again and thought that stocks looked cheap with the Dow at 13,000, 12,000, and 11,000, I couldn't buy into the notion that a massive contraction in credit could lead to higher stock prices.  I certainly believe that there are significant risks, but the risk reward equation has altered so much in the past several weeks that it has begun to look tempting to dip your toes in as others panic.  Furthermore, the Fed and Treasury are jumping through hoops to stimulate the market, and at some point the gears will start to move again.  I would still hold lots of cash in FDIC insured accounts, maybe some gold and perhaps some Damien Hirst artwork.  For those unfamiliar with Mr. Hirst's art, he puts dead animals into glass cubes filled with formaldehyde and calls it art.  Sotheby's held an auction where people tripped over themselves to pay $10's of millions of dollars apiece for dead animals in formaldehyde.  So, you see, this might be a really great store of value, tradable for canned goods in the event that the entire world collapses and we're left with nothing but a barter system.  I'm not saying I'll be sinking all of my money into Mr. Hirst's art, only that the neighborhood cat better watch out.        

   

Global Coordinated Rate Cut

The Fed, European Central Bank, Bank of Canada, and Sweden's Riksbank each cut their benchmark rates by 50 basis points.  China's central bank also lowered its one-year lending rate by .27%.  The drastic interest rate cuts, rumored for days, came on the heels of severe strains in the money markets and plunging global stock markets after dramatic government intervention around the world has failed to stem the crisis.

The UK will invest directly into its four largest banks and provide other funding totaling $87 billion.  The announcement was anticipated and caused a complete rout in British bank stocks yesterday.  The Nikkei plunged 9% and Indonesia halted trading after its benchmark index tumbled 10%.  Russia pumped another $36 billion in loans to its banks.  Promises of nearly $150 billion from the Russian government have failed to stop the Micex from plunging yet again.

Although futures are up after the rate cut announcement, it is hard to imagine that somehow this act is finally going to solve the crisis gripping the global markets.  It doesn't matter how low interest rates are if banks refuse to lend to each other because of counterparty credit risk fears.  The extraordinary actions that the Fed has instigated through a series of new lending facilities have only made banks more reluctant to lend to each other.  If you can get all of your financing through the Fed, why borrow from a financial institution who may or may not be around in six months?  The Fed and Treasury are praying that something at some point will restore confidence in the banking system again.  But if the TAF, TSLF, PDCF, CPFF, TARP, and various other loans to AIG, FNM, and FRE can't stop the meltdown, how on earth is another 50 basis points going to do the trick?  

Fed Paying Interest on Reserves, Increasing TAF, Jumping Through Hoops

The Fed has released a statement announcing significant efforts to boost liquidity in the credit markets.  The Fed will begin to pay interest on required reserve balances and excess reserve balances.  Additionally, the Fed will increase the amount outstanding in the Term Auction Facility (TAF) to a potential amount of $900 billion over year end.  The TAF auctions 28-day and 84-day loans to dealers in return for collateral accepted by the discount window (which currently includes all sort of questionable securities and possibly old shoes.)  The increase in the TAF is meant to alleviate strains in the term market for funds.  Apparently, banks are terrified of lending to each other for more than a few days because of counterparty credit risk fears.  The Fed is the only counterparty that is guaranteed to be around in a few months.  

While I do believe that these actions appear necessary to keep more banks from failing, I still find them extremely disturbing.  The Fed is propping up our banking sector.  How much longer will it work, and what happens if it fails to prevent more banking collapses?  If you thought the $700 billion bailout plan was big, how do you feel about the $900 billion TAF?  Or the $400 billion in "other loans" sitting on the Fed's balance sheet?  While the amount of assets on the Fed's balance sheet continues to increase, it is wise to remain cautious.  I'll be checking in with the Fed every Thursday afternoon for an update on its balance sheet as a decrease in assets will be a crucial indicator of when the worst really is over. 

 

Watered-Down Government Bailout Package Close To Completion

Although the bailout plan has not been finalized, lawmakers claim they will have a deal by Sunday night. The plan has been modified significantly from Paulson's original "Give me $700 Billion and don't ask any questions" proposal. You can read the full summary of the draft proposal on the Wall Street Journal's website. Some of the highlights include:

• Cuts the plan in half from original $700 billion, with congressional review required for more funding
• Gives taxpayers an ownership stake with participating companies
• Puts taxpayers first in line to recover assets if participating company fails
• Guarantees the taxpayers are repaid in full [intentionally vague?]
• Allows participation from pension plans, local governments and small banks
• Limits CEO compensation
• Recovers bonuses based on promised gains that later turn out to be false
• Allows government to facilitate mortgage modifications

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

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

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

Discount Window Borrowings Surge

Thursday afternoon's Federal Reserve balance sheet release was filled with painful evidence of how serious the liquidity squeeze remains for banks and dealers.  The significant increase in borrowing from the Fed would have been bigger news were it not overshadowed by the FDIC's seizure of WaMu and the fight over Paulson's $700 billion bailout package.  Primary dealers borrowed $105 billion from the Primary Dealer Credit Facility on September 24th, a shocking amount considering the stigma associated with borrowing from the discount window.  If you were curious why Goldman Sachs asked Warren Buffett for an investment or why the storied investment bank converted itself into a bank holding company, this is the answer.  Finding short-term financing is growing increasingly difficult and the Fed can't seem to create new lending facilities fast enough to keep up with demand for dollars.  Banks borrowed $72 billion from the new asset-backed commercial paper money market or mutual fund liquidity facility, a non-recourse loan facility offered to US depository institutions and bank holding companies to finance purchases of ABCP from money market funds.  The Fed is also accepting equities through the discount window, which I'm certain indicates that the financial apocalypse is upon us.  The loan to AIG has increased from $28 to $44 billion within a week.  I suppose AIG is still determined to pay off the loan and remain a non-government owned company, but it does not appear to be moving in the right direction.  The good news is, we still haven't lost any money on the Bear Stearns loan, although the last time the asset was valued was June 30th.  I'm awaiting the quarterly update and I'm assuming it is not good.

If the money markets don't thaw soon, and there is very little reason to believe that they will after WaMu's failure and the stall-out of the Paulson plan, the Fed will likely need another loan from the Treasury so it can increase its lending to the dealer community.  This is commonly known as running the printing press in a third world nation.  In the US, it's just Bernanke and Paulson doing what they do best; juicing up Wall Street so it can live to fight another day.  The Financial Times is reporting that Morgan Stanley lost close to a third of the assets in its prime brokerage last week (hundreds of billions of dollars) as hedge funds fled to rival banks.  The rumor circulated all last week, but was only published as news in a major financial publication for the first time tonight.  This is yet another unintended consequence of Lehman's failure.  Hedge fund clients are concerned that if Morgan fails due to the severe liquidity squeeze, they will wind up like Lehman's clients; unable to access their assets in a wildly fluctuating market.  Needless to say, concerns about the future of Morgan will likely hurt the market tomorrow.  At least this time, they won't blame the shorts.     

Cox Vs. Paulson: Contradictory Plans?

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

Cox:  Hello Hank?  This is Chris.

Paulson:  Who?

Cox:  Chris Cox, SEC Chairman.

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

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

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

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

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

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

Paulson:  WHAT?  

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

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

     

Fed Borrows $100 Billion From Treasury

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

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

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

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

Rating Agencies Put Nail in Coffin of AIG, WaMu

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

SEC Chairman Chris Cox has been remarkably quiet during the recent turmoil.  Perhaps he has finally discovered the joys of shorting stocks that go down 99% within weeks and is reluctant to impose restrictions.  If Mr. Cox wanted to make himself useful (which is questionable), he should've put a temporary freeze on rating agency downgrades rather than going after short sellers.  The agencies are too late to do anyone any good.  They are merely inciting further panic.  Note the 6% plunge in the Nikkei and the drop in the S&P futures after hours.  Prepare yourselves for another volatile day. 

AIG Rejects Private Equity, Potentially Committing a Fatal Error

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

Tomorrow will be a rough day in the market.  If things get too ugly the Fed might cut interest rates again, which would plant the seeds for the inflation of some other kind of bubble.  We've already been through tech and housing.  What next?  I'm betting on a mattress bubble, because that's where I'm keeping my money.   

Lehman Bankrupt, Bank of America Buying Merrill

Both Barclays and Bank of America opted out of purchasing Lehman.  No surprise.  I wouldn't have bought Lehman without a $60 billion guarantee from the Fed either.  My sources are telling me that a bankruptcy filing by Lehman is imminent.

Meanwhile, Bank of America has moved on to considering a purchase of Merrill Lynch.  Interestingly, a sale of Merrill wasn't even in the cards until this week when it became apparent that investors were losing confidence in any leveraged institution's ability to survive through the credit crunch.  No word on Washington Mutual or AIG's fate.  I guess we'll resolve those issues next weekend.     

Market Tumbles on Pervasive Fears of Financial Failures

Lehman is trading at $4 in the pre-market.  To answer myself from Tuesday's "Will Lehman Go To Zero? Today?" post: Yes, but apparently not until tomorrow.  Equity investors have given the firm up for dead as it has finally dawned on them that the investment bank cannot recover from this crisis of confidence.  Frankly, this is terrible news for the other investment banks as the business model is seriously being questioned.  One investment bank's failure can be viewed as a "one-off" capitulation event.  Another bank clinging to survival a mere six months later begs the question of whether investors want to bet on a model that relies on borrowing huge sums of money on a short term basis.

The market is also betting that Washington Mutual is toast, as the stock has fallen below $2.  Although this is not a surprise to anyone who knew of WaMu's option ARM portfolio (i.e. anyone reading Mock The Market for the past six months) and default rates hitting option ARMs, realization has finally dawned on the market like a ton of bricks in the past week.  What is a surprise to me, is that Wachovia is yet to hit the single digits, as its option ARM portfolio is over $120 billion.

Finally, AIG has been pummeled for the past few days on widening spreads in the CDS market.  As I mentioned in my last post about AIG's toxicity after its earnings announcement, "I don't care how good the insurance business is, until AIG figures out a way to mitigate the risk in its derivatives portfolio, the company will continue to post losses until the credit markets return to normal."  $441 billion in notional CDS?  $57.8 billion tied to subprime?  AIG is short volatility in the volatility perfect storm.  Furthermore, there is a story in the Financial Times addressing the losses that insurers are likely to suffer from the default on Fannie and Freddie CDS.  Apparently the recovery value is currently expected to be around 95 cents on the dollar on an estimated $200-$500 billion of outstanding contracts.  This translates into potential losses of $10-$25 billion for the insurance industry that offered credit insurance.  The International Swaps and Derivatives Association is expected to announce today which of the bond issues from Fannie and Freddie will be eligible to be used to settle the CDS.

Where do we go from here?  Who's next to fail?  How many more bailouts can the US grant? These are all the questions floating around in the market, which makes me think that we can only go lower from here.  

Lehman Posts Loss, Unveils Plan

Lehman posted a preliminary loss of $3.9 billion for the third quarter, much wider than the most pessimistic analyst estimates, and unveiled a restructuring plan in an effort to instill confidence in the wake of yesterday's 45% plunge in the stock.  The meat of the plan is to spin-off its commercial real estate assets to its shareholders and sell a stake in its prized asset-management unit.  The spin-off of the commercial real estate portfolio into a new company called Real Estate Investments Global accomplishes the task of stuffing shareholders with assets that they were hoping the bank would dump, but cushioning the investment bank from further losses in the portfolio.  Note to loyal shareholders: "Thanks! And you're wearing it!"  In the statement Lehman claims that REI Global's "primary focus would be to maximize shareholder returns by selling assets or holding them to maturity."  In my opinion, this is a fancy way to get around the indignity of having to mark these securities to market.  Furthermore, if anyone actually wanted these assets at the valuation that Lehman placed on them, Lehman would've gladly sold them and taken cold hard cash in return.

The investment bank is selling a 55% stake in a subset of its investment management division including asset management, private equity and wealth management.  It is in advanced discussions with a number of potential partners and will announce details of the transaction in "due course."  The asset management sale will be completed in an auction.  Given the recent performance of Lehman's stock price and the absence of alternatives to raise capital for the firm, I would bet that the potential bidders may be shaving a few bucks off of their bids.

In any event, the suspense is over.  Lehman has announced its plans, and investors have reacted with muted interest.  Although the stock has regained what it initially lost in pre-market trading, it is barely up after the precipitous plunge in the shares yesterday.  Continued declines in the stock show a lack of confidence and will be terrible for financials on the heels of yesterday's losses.  Prepare yourselves for yet another bumpy ride.

Will Lehman Go To Zero? Today?

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

Bailouts, CDS Defaults, and DeJa Vu

The historic bailout of Fannie and Freddie by the US Treasury turned out to be only one story in a very interesting and volatile trading day yesterday.  The repercussions of the Treasury's action will be weighed for some time, however, the tightening of mortgage bond spreads seems to be the most positive immediate benefit of the plan.  Spreads on agency MBS came in around 40 basis points, giving the entire banking sector a nice mark-to-market gain.  Interestingly, this was a huge boost to Paulson's equity investment in Fannie and Freddie, as the two firms hold enormous mortgage portfolios.  It appears as if Mr. Paulson learned a thing or two about front-running a trade from his time at Goldman.  The tightening of mortgage spreads, however, did not filter out into the rest of the bond market, indicating that the credit markets are still nervous.

Falling in the category of significant unintended consequences of the bailout was the event of default triggered in the CDS market by the conservatorship.  The ISDA will settle the CDS through cash auctions that will likely take 30 days.  It should prove to be nothing more than a back-office nightmare, unless, of course, somebody finds a huge out-trade.  Apparently the CDS market has grown exponentially, despite the fact that the settlement process is performed through the use of fax machines rather than electronic confirms.  I predict at least a few cases of "No no no!  We definitely sold these.  We were not buyers!  I don't care what your stupid confirm says.  Look it doesn't matter that I can't actually find and produce my confirm, my trader says it was a sell and there is no way I'm going to tell him that I can't find the confirm!"

In bizarre and completely unrelated news, UAL declared bankruptcy in 2002.  Unfortunately, the story was so compelling that it was posted as a new headline yesterday and picked up by Bloomberg.  I suppose it seemed so probable that UAL could file for bankruptcy again, that investors didn't even bother to actually read the story before dumping the stock.  UAL adamantly denied the filing and the error was eventually discovered.  For savvy traders who were paying attention, there was a small window of opportunity to buy UAL at $3 before trading was halted.  

The Lehman saga continues unabated.  Reports this morning about KDB officially ending talks about taking a significant stake in the firm are crushing the stock.  Lehman's options for a private sector rescue continue to narrow, which means its days are numbered.  Something tells me that by the end of the week the enthusiasm surrounding the bailout of Fannie and Freddie will be a distant memory.

  

     

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

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

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

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

When Hank Paulson took his post as US Treasury Secretary, he probably thought it would be a nice relaxing break from the high-stress job of running Goldman Sachs.  After all, what does a Treasury Secretary do, other than shake hands with figureheads and make emphatic statements claiming to support his administration's "strong dollar policy?"  Mr. Paulson, however, has found himself in the difficult position of attempting to bailout most of the US financial sector while avoiding the use of taxpayer funds.  The US market narrowly avoided a complete meltdown in March when Paulson forced JP Morgan to buy Bear Stearns.  It would've been the perfect plan were it not for the $29 billion in dicey mortgages that the Fed has guaranteed for JP Morgan.  No use of taxpayer funds, yet.  Expanding the type of collateral that the Fed will take in its loans to Wall Street to include triple AAA rated MBS and ABS was also inspired genius, assuming that none of these institutions fail and leaves the Fed holding undesirable collateral in a panicky market.  Opening the discount window to investment banks was a shrewd move to shore up confidence and keep Lehman from facing Bear's fate in March.  Investment banks have yet to tap the discount window.  So far, so good.  When Fannie and Freddie's stocks began to plummet on fears that they were insolvent, Paulson crammed through a landmark housing bill that had stalled in congress in order to make the implied government guarantee explicit.  Although I am not a mind reader, I believe that Paulson was hoping that the explicit guarantee would boost confidence so much that the government would never have to take an equity stake in the faltering mortgage entities.  The market, however has called his bluff.  Fannie and Freddie's shares have been reeling, dragging down the recently rebounded financial sector on a belief that the government will have to make an equity infusion that will wipe out the common and potentially the preferred shareholders.

Since desperate times call for desperate measures, I have a crazy plan for Mr. Paulson on how to save Fannie, Freddie and Lehman while making a few bucks in the stock market.  First, call Lehman Brothers and tell them that the government plans to buy one billion shares of Fannie and Freddie tomorrow, giving Lehman one trading day to front-run the order.  Then, Mr. Paulson can give the order to Lehman to buy one billion shares the following day at the market.  Since this is around ten times the average daily volume, both of the stocks should spike significantly.  A short squeeze will follow as the small-time shorts get squeezed out.  Mr. Paulson can then call Chris Cook at the SEC and tell him to put out an emergency short-sale ban.  The SEC must outlaw ALL shorting, not just the naked variety.  The stocks will surge higher as shorts are forced to cover.  Once both share prices have quadrupled, Fannie and Freddie can raise more capital from a few strategic foreign investors.  After all, this has got to look like a great investment compared to the Chinese or Indian stock markets of late.  Although the government's share will be diluted by the new capital raising, it should be more than offset by the appreciation in the stock.  Lehman, having front-run the buy side, can also front-run the equity issuance and post a gain that may help offset the $4 billion or so in losses that it is more than likely to have this quarter.

If all of this sounds crazy, then you haven't been keeping up with current events.  It only seems slightly more crazy than the reality confronting the market.  Fannie and Freddie on the verge of a direct equity infusion from the government?  Insanity!  Lehman's stock getting annihilated again because all of those "rumors" about untenable losses turned out to be true?  Shocking!  Is everyone at Lehman "comfortable" with those marks now that the investment bank is yet again desperately searching for new ways to raise capital?  Erin Callan can thank Dick Fuld for giving her the boot, as it was a better move for her career than Mr. Fuld's.  Mr. Fuld has nowhere else to point the finger.

Only time will tell how the turmoil in the financial markets will finally be resolved.  You can bet on more surprises along the way.  The only thing that seems certain is that the financial universe will continue to shrink as players get weeded out during the downturn.  Pundits attempting to call the bottom will eventually grow weary.  Only when completely crazy ideas begin to sound reasonable will a bottom begin to form.  When I get a call from Mr. Paulson asking for the outline of my plan, I'll let you know it's safe to buy financials again. 

  

AIG: What's Another $5.36 Billion?

AIG reported a loss of $5.36 billion, or $2.06 a share in the second quarter, significantly worse than average analysts estimates.  Why the analysts had this one so wrong is anybody's guess.  It is widely known, and has been reported several times here at Mock The Market, that AIG has a monstrous portfolio of credit default swaps.  As of the end of June, AIG guaranteed $441 billion of assets, $57.8 billion tied to subprime, down from $469.5 billion and $60.6 billion respectively as of March 31.  Note that the subprime number has barely declined, indicating that the company is trying to dispose of the most liquid assets first, hardly a good sign.  If you are an analyst following this stock and aren't keeping track of what is going on in the credit default swap market, you are not very good at your job.  Frankly, I don't care how good the insurance business is, until AIG figures out a way to mitigate the risk in its derivatives portfolio, the company will continue to post losses until the credit markets return to normal.  First, find the bottom in housing, then find the turning point in credit, then put out a rosy report on the company's prospects.  Hear that, Mr UBS analyst who thought this was a "buy" two days before this disastrous earnings report?

AIG wrote down the value of credit-default swaps by $5.56 billion in the second quarter.  Even more disconcerting, the company has had to post $16.5 billion of collateral as of July 31st and said it is unable to determine the effect "that recent transactions involving sales of large portfolios of CDOs will have on collateral posting requirements."  What does that statement mean to me?  The company has no idea how much more money it will need to raise.  In the "yet even more disconcerting" department, AIG raised its estimate for how much it will have to pay on its swaps, from $2.4 billion to $8.5 billion.  AIG also marked down the value of investments by $6.08 billion after "severe rapid" drops in the value of securities backed by home loans.  The good news is that excluding the declines in the value of some investments, AIG only lost $1.32 billion!  What a relief!  The company only lost $1 billion in its core operations.  I smell another 330 point rally in the Dow.     

Ambac Earnings Report Requires Interpreter

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

Freddie Mac Posts Loss, Cuts Dividend

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