There are two kinds of people in the world, my friend.
Those who have a rope around their neck and those who
have the job of doing the cutting.
- The Good, the Bad and the Ugly
The Great Debt Experiment has now morphed into the Great Credit Unwind, and we are asking ourselves how this will all end. My answer has been ‘I Don’t Know,’ as I wrote in my piece last December. The reason for the answer was that I felt (and still do) that the buildup in debt, leverage and derivatives is so unprecedented that the fallout from the buildup should be unprecedented as well.
So while I keep hearing tales of bailouts and a bottom forming in the credit markets, I could not disagree more. In my mind, the unwind has just begun and if anything will accelerate in coming months as more and more companies, mostly financial institutions, will have an incredible need for capital—capital that is needed to simply remain in business. This may sound draconian, but as I have been saying for years, when the unwinding process begins, it will not be pretty.
Forced Marriages: The Good Bank/Bad Bank Scenario
Several weeks ago, I wrote about the balance sheet issues surrounding Bear Stearns (BSC) and Lehman Brothers (LEH). Considering how leveraged these have become, any misstep is magnified and results in a lack of financing, which is critically needed to remain solvent. Simply stated, if your balance sheet is levered 35 to 1, and you have four times as many ‘Level 3 assets’ as you do capital, you could be in deep trouble if one or more counter-parties decides they don’t want the other side of your trades.
This occurred in the case of Drexel Burnham Lambert about 20 years ago, and happened to Bear Stearns two weeks ago. Since all of the major investment banks, commercial banks and hedge funds are so intertwined, the Federal Reserve stepped in and took $30 billion of ‘hard to price’ securities off the hands of J.P. Morgan (JPM) and let it buy Bear Stearns for a song. Whether or not it'll be able to retain Bear’s talented people after giving them $10 per share (down from $160 last year) remains to be seen. Many of these talented individuals could flee to other firms in exchange for large signing bonuses and we still don’t know exactly what was on the balance sheet of Bear after the $30 billion of truly esoteric securities were handed to the Fed.
This type of behavior occurred in Japan in the early 1990’s after its real estate and stock market bubbles were deflated. The good bank (in this case, JPM) gets a steal while the bad bank (in this case, Bear Stearns) gets the shaft. The question in my mind, however, is how many "good banks" are left to absorb all of the "bad banks"? In a nutshell, I believe the answer is "not enough." In the middle are the "not-so-good banks"—those that are too big to be taken over and too leveraged to play "good bank." I guess they are just stuck in the middle.
Yes, I'm stuck in the middle with you
And I'm wonderin' what it is I should do...
Clowns to left of me, jokers to the right
Here am I stuck in the middle with you.
—Stealer's Wheel
Bad Banks Defined
Without naming names quite yet, what would you think of a company that accomplished the following in 2007?
I could cite 20 or more similar financial ratios and they are all stunning. Who is this firm? Merrill Lynch (MER)
Some statistics on another potential bad bank:
Who is this firm? Morgan Stanley (MS). Again, these numbers seem tragic to me when I consider what would happen if the company was actually forced to write down its "hard to price, hard to sell" assets.
There are only two solutions in my mind for what can happen to these firms. They can raise capital or sell themselves, perhaps for not very much. The capital raises I foresee in the second quarter might be something for the record books. Fannie Mae (FNM) and Freddie Mac (FRE) may need to raise up to $20 billion this year through a combination of preferred, convertible preferred stock and equity to get their financial ratios into OFHEO compliance, as they are being asked to pick up the slack of the hundreds of mortgage lenders that have gone bad and the commercial banks that are now backing away from lending. I just read a news story where UBS (UBS) may need to raise upwards of $16 billion. Merrill, BankAmerica (BAC), Wachovia (WB), Morgan Stanley, HSBC (owner of Household Finance), and many others will not be far behind.
How long will market participants be available to buy all of this new paper? My general take is not for long. While the Fed takes rates closer to zero, most large preferred stock deals have remained in the 8% area. If Merrill et al needs to raise upwards of $100 billion just to remain solvent, what rate would I pay for this paper? I hate to say it, but it would be somewhere north of 10% and as high as 12-15%. I just don’t see the value when I can buy Fannie/Freddie paper at 8 ½%. And what happens if they have to pay that rate? Profitability shrinks. In other words, the credit unwinding is like watching a train wreck in slow motion.
There are other bad banks, such as CIT (CIT), a global and consumer finance company that is slowly eating away at its capital base. It's in so much trouble that it recently had to draw down a $7 billion credit line just to avoid insolvency. It might fit very well into the likes of a GECC. Again, common shareholders may not like the price but it could be a great big/bank fit.
Another bad bank might be Cleveland-based National City Corp (NCC). It's recently been forced to pay 12% in a corporate debt offering and nearly 10% in a preferred stock offering. Rumors circulate almost daily about an imminent buyout, but if you were a buyer, would you really want to buy a bank that has HELOCs (home equity letter of credit) on homes in industrial states such as Ohio and Michigan and in the previously hot states of Florida and Nevada?
Not to mention all of the smaller, regional and community banks that based their lending model around real estate based loans. So you see, the problem is much more pervasive than many think. Then there is FGIC, which was just downgraded to junk bond status the other day. I am sure Ambac (ABK) and MBIA (MBI) are not far behind as their models are hopelessly broken. They had perfectly good business models until greed took over. I think they will all just disappear.
OK. All of this is rather sobering, so the real question becomes how does one take advantage of these opportunities? For quite a long time, my firm was long GSE preferred equity and short preferred equities of broker/dealers, particularly Bear, Lehman and Merrill. But two weeks ago, when the shotgun wedding of JPM/Bear finished and rumors began circulating about Lehman’s solvency, I removed all short side bets against the brokers and shrunk the long position in Fannie/Freddie.
Since that time, however, I have initiated short positions in preferred shares in the ‘not-so-good’ banks, like Wachovia, Wells Fargo (WFC), etc. It seems ludicrous to me that we can buy Agency preferred shares with a ‘tax equivalent yield’ around 11.5% and short preferred of Wells Fargo that are fully taxable and yielded barely 7.2% at the time the trade was initiated.
In other words, I am getting paid to short credit risk. The reasoning behind this trade is that I'm a bit afraid that if a good bank bought a bad bank and I was short their debt, the debt could be assumed by the buyer, making the debt worth more, even while possibly wiping out equity holders. And to short the debt of the good bank that is getting a great deal (even though I have to admit being short JPM preferred stock as it's hopelessly overvalued in my book) may not be the best way to go.
But the ones in the middle that are too big to buy and in too poor a shape to absorb a struggling bank seems the best bet. Keep in mind that this is not a bet against the common shares, just the preferred shares, as I expect that the tidal wave of issuance could "re-price" the entire sector, and in the meantime we will simply collect the "positive carry." A worst case scenario in my mind is that the entire preferred stock space is re-priced and my longs and shorts fall together. While possible, it's not the most likely scenario, but I'm prepared for such an occurrence.
FRE 8 3/8% Preferred Stock
WFC 7% Preferred Stock
What about the buyer of last resort, the Federal Reserve? The Fed releases its balance sheet weekly and below is its latest balance sheet as of March 27th. Year-over-year direct holding of Treasuries fell by a whopping $151.9 billion and were replaced with assets from the balance sheets of not only commercial banks, but also from primary dealers. This is unprecedented activity by the Fed. They used to only lend at the discount window to troubled commercial banks. And they only took Treasuries as collateral. But now they take in not only Treasuries, but agency paper, and more importantly, non agency AAA CMO’s.
We do not have a listing of the exact securities they have on their balance sheet, but if you were a primary dealer with a host of securities that were ‘hard to price’ or ‘hard to sell’ and were AAA rated, wouldn’t you hand them over to the Fed in exchange for Treasuries?
If I owned securities that were falling in value and had deteriorating credit, I would be left to sell my securities into the open market and take my loss. So "where is my bailout when I make a mistake"? It seems that the Fed, unless it's granted a lot more liquidity from Congress, may have set a rather dangerous precedent of stepping directly into what used to be a free market and now is tinkering with a financial system that needs more than a band-aid. Rather, it's in need of a tourniquet.
Condition Statement of Federal Reserve Banks, March 27, 2008
Ouch! That's My ARS!
About a month back, I wrote an article entitled Pain in the ARS. ARS, or Auction Rate Securities are now beginning to make headlines and could prove extremely damaging to investors and the dealers that sold them to investors.
ARS work in the following way. Suppose that you want to build a closed end municipal bond fund and be able to pay the broker 7% selling concession, charge 1% a year, and still pay the buyer a reasonable return. The only way to accomplish this is to leverage the fund. The fund levers up by selling ARS, or preferred stock at rates below the rates the fund earns on long term bonds purchased; essentially a "positive carry trade," and this worked for the last 20 years or so. Even though the securities have 40 year maturity dates, they are auctioned off every seven or 28 days, depending on the issue.
The securities yield a bit more than traditional money market funds and were considered "cash equivalents" when in reality they are very long term bonds that reset every so often, so long as there is a buyer and the auction doesn’t "fail" to attract enough buyers to reset the rate. What happens in a failed auction? The owner cannot get their money back from the brokerage firm—they simply have to stick it out until enough buyers are found to avoid failure.
When brokerage firms were flush with cash and making lots of money from traditional activities like investment banking, auctions never failed. The dealer simply stepped up and bought the remaining ARS and kept the auction from failing. These days, however, the dealers, like UBS (UBS), Merrill and Morgan Stanley are in dire need of capital themselves, leaving the investor to hold the security, perhaps for the entire duration, or 40 years.
This brings to light several important points. First, you are stuck in the security for possibly a long time, but failed auctions pay investors the "maximum rate" as defined by the prospectus, which on the surface sounds good. But in reality, most of the shares associated with closed end bond funds have a maximum rate of 110% of commercial paper.
Blackrock Muni Insured Floating Rate History
Blackrock Muni Insured Maturity Data
Note the "workout date" of 12/31/49. That is 41.75 years for those counting. And with the commercial paper index plummeting along with Fed Funds, I fully expect commercial paper rates to settle as low as 2%, which would net the ARS holder a whopping 2.2% and no liquidity.
So what is happening? UBS announced on Friday that it'll begin to mark the securities to market (as if there actually were a market). They haven’t yet disclosed their pricing methodology but I have one of my own. If someone asked me to buy this security, I would demand a yield of 10%. After all, I can buy agency preferred stock at 12% tax equivalent yield with loads of liquidity. Where would that bond trade? Yikes: something on the order of 23 cents on the dollar, as my table below shows.
Theoretical Price for a 2.2% ARS
There are actually some examples that are actually worse than this. Some student loan-backed ARS have reset to zero coupons. What would I pay for a forty year security with no yield? Zero.
So brokerage firms are about to feel some heat. Investors, no matter how naive, were sold the ARS with the belief that they actually were cash equivalents. The securities will now be reclassified and written down in price simultaneously. The investor will no doubt sue, and the brokers, who to be frank are barely compensated for placing ARS in the client account, may be rather upset as well as the phones begin to ring off the hook. And this is a huge market—somewhere in the vicinity of $300 billion. When they get written down, expect the class action suits to start flying, right at the folks with no balance sheet.
The greedy are now being penalized. It's now possible that the good, the bad, the not-so-good and the ugly will all get hurt at once. Such is the unwinding of greed.
source: 2apr2008
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